Arbitrage: A Brief Introduction

Transcription

1 Daniel Schwartz FALL 2009 Arbitrage: A Brief Introduction Arbitrage strategies use relative value trades to generate excess returns with attractive risk profiles. Their low betas with respect to traditional asset classes make arbitrage strategies particularly effective components of a diversified portfolio. This paper offers a brief introduction to arbitrage, including descriptions of several common strategies and an overview of their historical performance. The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC ( AQR ) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. This document is subject to further review and revision. PLEASE SEE IMPORTANT INFORMATION AND RISK DISCLOSURES ON THE LAST PAGE.

2 WHAT IS ARBITRAGE? Arbitrage strategies are often defined as riskless profit opportunities. They consist of the simultaneous purchase and sale of two assets that are substantially similar or related, but that have different prices. By being long the cheap asset and short the expensive asset, an arbitrageur seeks to profit from an eventual price convergence. Since the real world presents very few truly riskless opportunities, arbitrage strategies are more accurately defined as relative value trades that offer attractive risk-adjusted returns. For investors, especially in light of the events of 2008, arbitrage has another desirable characteristic: low beta with respect to traditional asset classes. While all types of arbitrage have some risk, in most cases this risk is largely independent of equity and debt markets. For this reason, arbitrage strategies are often referred to as market-neutral. Over the long term, these market-neutral strategies can improve a portfolio s risk/return profile by reducing portfolio volatility through market cycles. COMMON TYPES OF ARBITRAGE In theory, arbitrage opportunities are possible for virtually every kind of asset, wherever price discrepancies occur. In practice, transaction costs and other frictions limit the investable universe of arbitrage strategies. This paper focuses on several common arbitrage strategies, namely: merger arbitrage, convertible bond arbitrage, and other event-driven arbitrage strategies. Merger Arbitrage When a merger is announced, the target company s stock price generally increases, but not fully to the price offered by the acquirer. The remaining spread reflects the risk that the merger will not be completed. Arbitrageurs can earn this positive spread for deals that are successful if they are willing to assume the risk that the deal fails an event that typically results in a large loss. Seen another way, arbitrageurs capture a risk premium in exchange for providing liquidity to those investors who no longer have a desire to hold shares in a target company and bear the risk of deal failure. Most mergers fall into two general categories defined by the form of payment: cash mergers and stock mergers. InBev NV s 2008 acquisition of Anheuser- Busch is an example of a cash merger. The day after InBev announced its intention to purchase Anheuser- Busch for $70 per share, Anheuser-Busch s stock price rose to $ The typical merger arbitrage trade would be to buy Anheuser-Busch for $66.60 and to sell Anheuser-Busch stock to InBev for $70.00 upon consummation of the merger. In addition, the arbitrageur would collect dividends on Anheuser- Busch stock paid prior to the merger closing date. Including $0.74/share in dividends, the spread between the offer price and the market price was 6.2%. Amortizing this spread over the 126 days until deal completion provided a potential annualized return of 19.1%. Because the offer price in a cash merger is fixed, capturing the arbitrage spread can be accomplished simply by purchasing the target stock. However, in a stock merger, capturing the arbitrage spread requires the purchase of the target s stock and the simultaneous short selling of the acquirer s stock. The 2008 acquisition of Merrill Lynch (MER) by Bank of America (BAC) is a recent example of a stock merger. BAC offered 0.86 shares of its stock for each share of MER, an offer that amounted to $25.40 per share. After the announcement, MER jumped to $22.18, leaving a deal spread of 14.5% over the following 107 days to expected completion, providing an attractive potential annualized return of 58.7%. The typical arbitrage trade would be to buy MER stock and to sell short 0.86 BAC shares for each MER share purchased. Arbitrageurs who implemented this trade isolated the spread between the two stock prices, and created a market-neutral investment whose primary 2 FOR INVESTMENT PROFESSIONAL USE ONLY Please read important disclosures at the end

3 Exhibit 1: HFRI Merger Arbitrage Monthly Returns January 1990 July % HFRI Merger Arbitrage Monthly Returns January 1990 July % Monthly Return 0% -2% -4% -6% -8% Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Source: Hedge Fund Research, Inc. 2009, risk was that of deal failure. In this way, merger arbitrage is analogous to writing insurance against deal failure. A merger arbitrageur collects a positive spread on the many merger deals that are completed, but faces the potential for loss when a merger fails. By investing in a sufficiently large number of merger deals, and by employing appropriate risk controls, the arbitrageur is able to build a portfolio that seeks to generate attractive returns with little systematic risk. However, as first demonstrated by Mitchell and Pulvino (The Journal of Finance, 2001) i, in a falling stock market, merger arbitrage has a historical beta of approximately 0.3. As the market declines, cash buyers often seek to re-negotiate the purchase price or terminate the merger, and thus cash mergers have a greater tendency to fail when markets decline. However, the impact on merger arbitrage strategies is typically modest and downturns rarely last longer than 1-3 months (see Exhibit 1). Convertible Bond Arbitrage A convertible bond is a corporate bond that can, at the option of the holder, be converted into common stock. Because of the conversion feature, a convertible bond is a hybrid security that bundles together a corporate bond and an equity call option. Each convertible bond has a conversion ratio which is the number of shares into which the bond may be converted. The conversion price is the stock price at which the holder is indifferent between receiving par value and converting the bond into common stock. Therefore, the conversion price is effectively the strike price of the embedded stock option. FOR INVESTMENT PROFESSIONAL USE ONLY Please read important disclosures at the end 3

4 In theory, a convertible bond s fundamental value is simply the sum of the values of its two components, each of which can be determined in a fairly straightforward manner. The strategy in convertible bond arbitrage is to identify situations in which the convertible bond is trading at a discount to its fundamental value. When this occurs, arbitrageurs buy the convertible bond and synthetically sell the embedded call option by short selling the company s common stock. By doing so, arbitrageurs capture the spread (the difference between market value and fundamental value) as the bond matures, is put to the company, or is called by the company, bearing the risk of a limited secondary market. By building a diversified portfolio and by employing portfolio level credit and interest rate hedges, convertible arbitrageurs seek to generate excess returns that have low correlation with traditional asset classes. An example of a convertible arbitrage trade involves the $600 million convertible bond issue by Textron in April Each $1,000 face value bond is convertible into shares of Textron common stock. The bonds began trading in the secondary market at a price of $ Based on the credit spread from a Textron bond with similar maturity and seniority, but without the embedded call option, the bond portion of the Textron convertible was worth $ Furthermore, call options with the strike price and expiration date similar to the option embedded in the convertible bond were trading at $0.69 providing value of $ Thus, the sum of the components were worth $ and therefore the convertible bond was trading at an approximately 8% discount to fundamental value. Convertible arbitrageurs sought to profit from this discrepancy by buying the convertible bond, short selling the underlying common stock, and hedging the bond s contribution to portfolio credit and interest rate risk. Event-driven Arbitrage Strategies Merger arbitrage and convertible bond arbitrage are probably the most well-known arbitrage strategies. There are, however, a number of other miscellaneous arbitrage strategies that are typically classified under the broad name event arbitrage. A few common types of event arbitrage strategies are described below. Stub Trades Arbitrage opportunities often arise when a publicly traded firm has an ownership stake in a publicly traded subsidiary. If the value of the parent s ownership stake in the subsidiary is large relative to the value of the parent firm, the value of the parent s remaining assets can be undervalued. The arbitrage strategy is to buy the parent stock and short the subsidiary stock based on the number of subsidiary shares held by the parent firm. By undertaking this trade, the arbitrageur isolates the value of the stub assets, which if undervalued should appreciate through time. A stub-trade arbitrage opportunity occurred in November 2008 when Time Warner (TWX) decided to split-off Time Warner Cable (TWC). As part of the deal, TWX would exchange shares of TWC for every share of TWX. TWC closed at $17.99 on November 20, 2008 making shares of TWC worth $ TWX closed at $8.14 on the same date. As a stub is the value of the parent s assets less their stake in the subsidiary, the implied stub price was $ This compares to an estimate of $ for the fair value of the stub and suggests that the stub was trading at more than a 40% discount. Stated differently, the market price of $8.14 for TWX, was far less than the sum of the parts of TWX at $ ,ii. To capture this price discrepancy, an arbitrageur would short shares of TWC for every share of TWX with the expectation that the stub would appreciate over time. 1 Conversion ratio * Market price of option $0.69=$ Value of straight bond $ Value of embedded option $52.49=$ Market price of TWC $17.99 * Exchange ratio of spin-off =$ Market price of TWX $8.14- Value of TWC when exchanged $4.49=$ Jefferies Equity Research, November Fair value of stub $ Market value of exchanged shares of TWC $4.49= $ FOR INVESTMENT PROFESSIONAL USE ONLY Please read important disclosures at the end

5 When-issued Arbitrage When-issued arbitrage opportunities arise immediately prior to spin-offs and other corporate actions. At that point, up to four securities are traded in the market: Parent shares, Subsidiary shares, When-Issued Parent shares and When-Issued Subsidiary shares. A when-issued parent share is the stock that begins to trade prior to a spin-off but reflects firm assets after the spin-off (i.e. when-issued parent shares reflect parent shares without the subsidiary assets). A when-issued subsidiary share is simply a right to receive a subsidiary share following the spin-off. When-issued subsidiary and when-issued parent shares often trade at premia or discounts to the regular subsidiary and parent shares. Arbitrageurs capture price discrepancies by buying and shorting shares of the parent, the subsidiary, and the when-issued shares. A when issued arbitrage opportunity occurred with Altria s spin-off of Kraft in March Altria distributed approximately 89% of Kraft s outstanding shares owned by Altria to Altria shareholders. Specifically, for each outstanding share of Altria, Altria distributed 0.7 shares of Kraft. On March 22, Altria closed at $86.15 and Kraft closed at $ The theoretical value of the Altria stub (Altria ex-kraft), was $ However, the when-issued stock of Altria closed at $ To capture this price discrepancy, an arbitrageur would buy Altria and short both Kraft and when-issued Altria (w/o-kraft). Dual-Class Arbitrage Dual-class stocks are different classes of common stock issued by the same company. Companies issue different share classes for various reasons, but it usually involves tax and control considerations. Typically, each class of stock is entitled to the same cash flow interest in the company, but one share class has superior voting rights (e.g. 10 votes per share). As the stocks are traded, technical market forces can cause prices of the different classes to diverge. When this occurs, a dual-class arbitrage opportunity arises and an arbitrageur can earn the spread between the two classes. The typical dual class arbitrage trade is to wait for the spread to become abnormally large and then buy the cheap class of stock and short the expensive one, taking on the risk that the anticipated spread reversion takes a long time to occur. This type of arbitrage opportunity arose with Royal Dutch Shell in the second quarter of On April 11, Royal Dutch Shell Class-A stock closed at $66.83 while Royal Dutch Shell Class-B closed at $ Arbitrageurs could have bought Class-B and shorted Class-A. When the stock prices did converge on May 2, the positions would have been sold and the spread realized. SPACs (Special Purpose Acquisition Companies) are publicly traded shell companies whose primary asset is a trust account invested in low-risk securities such as Treasury bills. SPAC managers are typically given months to find an operating company to purchase using the assets of the trust account. Once the SPAC managers have found a candidate company, the acquisition is presented to shareholders for a vote. If the vote fails, money from the trust account is returned to shareholders on a pro-rata basis. However, even if the vote succeeds, shareholders who vote against the acquisition are allowed to redeem their pro-rata share of the trust account. Under normal market conditions, SPACs trade at close to fundamental value the value of the Treasury bills in the trust account. However, during market dislocations, SPAC prices can trade at discounts, creating arbitrage opportunities. Under these circumstances, arbitrageurs capture the discount by voting against acquisitions and receiving their pro-rata portion of the trust account, paid in cash. Assuming the opportunities are properly identified, SPACs represent a relatively low risk arbitrage strategy. 7 Market price of Altria $ Market price of Kraft $31.85 = $63.85 FOR INVESTMENT PROFESSIONAL USE ONLY Please read important disclosures at the end 5

6 Exhibit 2: HFRI Index Returns January 1990 July 2009 HFRI Merger Arbitrage Index HFRI Convertible Arbitrage Index HFRI Event Arbitrage Index S&P 500 Index Merrill Lynch 3-Month T-Bill Index Annualized Return 9.5% 8.5% 12.2% 5.4% 3.9% Volatility 4.3% 6.6% 7.0% 15.1% 0.5% Sharpe Ratio Alpha (annual) 5.1% 4.2% 7.4% 0.0% 0.0% Beta to S&P Source: Hedge Fund Research, Inc. 2009, RISK AND RETURN CHARACTERISTICS OF ARBITRAGE STRATEGIES Arbitrage strategies have a long history of attractive risk-adjusted returns. Exhibit 2 shows the performance of the HFRI Merger Arbitrage, HFRI Convertible Arbitrage, and HFRI Event-Driven Arbitrage Indices compared to U.S. equity and U.S. Treasury Indices. The alphas, or excess returns, of the arbitrage strategies range from 2.5% to 7% with volatilities between 4% and 7%, substantially lower than the U.S. equity market. Low betas relative to the S&P 500 and attractive Sharpe ratios are key reasons investors look to diversify their portfolios with arbitrage strategies. ARBITRAGE AND THE DIVERSIFIED PORTFOLIO To illustrate the diversification benefits of arbitrage strategies, we compare two hypothetical portfolios: a standard portfolio to a hypothetical enhanced portfolio that includes arbitrage strategies from the period January 1990 through July The standard portfolio consists of 60% stocks, 30% bonds, and 10% cash 8. The modified portfolio features a 15% arbitrage component, taken equally from stocks, bonds, and cash and placed into the HFRI Merger Arbitrage, Convertible Arbitrage, and Event-Drive Arbitrage Indices. As shown in Exhibit 3, the inclusion of arbitrage strategies enhances returns while decreasing volatility, resulting in a much improved Sharpe ratio 9. Exhibit 3: Adding Arbitrage to a Standard Portfolio Hypothetical Example Standarized Portfolio (60% stocks, 30% bonds, 10% cash) Enhanced Portfolio (55% stocks, 25% bonds, 5% cash, 15% arbitrage) Annualized Return 6.01% 6.70% Volatility 9.32% 7.60% Sharpe Ratio Source: Hege Fund Research, Inc. 2009, 8 Stock returns are taken from the S&P 500, bond returns are taken from the Lehman Aggregate Bond Index and cash returns are taken from the Merrill Lynch 3 Month T-Bill Index. 9 Hypothetical performance has many inherent limitations and is for illustrative purposes only. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. 6 FOR INVESTMENT PROFESSIONAL USE ONLY Please read important disclosures at the end

7 CONCLUSION Recent history has reminded investors of the importance of diversification. Many individual arbitrage strategies have low betas with respect to traditional investment classes and, importantly, with respect to each other. While not immune to global economic crises, we have seen that arbitrage strategies generally fall less than equity markets, and, because of the convergence nature of the trades, tend to recover losses following crises. For long-term investors looking to enhance risk-adjusted returns through market cycles, we think exposure to arbitrage strategies is a practical option. i Mitchell, Mark and Todd Pulvino, Characteristics of Risk and Return in Risk Arbitrage, Journal of Finance, December, ii Jefferies Equity Research Report, Special Opportunities, November 20, DISCLOSURES: The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC its affiliates, or its employees. The information set forth herein has been obtained or derived from sources believed by author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information s accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by the author, and it is not to be reproduced or redistributed to any other person. Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Hypothetical performance results are presented for illustrative purposes only. The arbitrage transactions described herein are strictly for educational purposes and are in no way a recommendation of specific securities or services. There is no guarantee that these strategies will be successful. FOR INVESTMENT PROFESSIONAL USE ONLY Please read important disclosures at the end 7

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