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Arbitrage

Arbitrage. November 10, 2008. Arbitrage. A “riskless profit.” The simultaneous purchase and sale of an asset in order to profit from a difference in price. Risk Arbitrage. Arbitrage that contains an element of risk. May include: Merger Arbitrage Liquidation Arbitrage Pairs Trading

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Arbitrage

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  1. Arbitrage November 10, 2008

  2. Arbitrage • A “riskless profit.” • The simultaneous purchase and sale of an asset in order to profit from a difference in price.

  3. Risk Arbitrage • Arbitrage that contains an element of risk. • May include: • Merger Arbitrage • Liquidation Arbitrage • Pairs Trading • Hedge fund trades.

  4. Merger and Buyout Arbitrage • Merger arbitrage usually involves buying shares of one company and shorting shares of another company (in the case of an equity exchange deal). • Buyout arbitrage involves “betting” that a buyout will in fact occur. • For the buyout setting to be profitable, the stock must trade at a discount to the buyout price.

  5. Rohm and Haas Co. (ROH) • DOW offered to acquire ROH for $78 per share in cash. • ROH shareholders approved deal. • Financing, etc. should be secured. • Expected to close in early 2009. • ROH currently trading around $73-74. • Potential for a 5% gain.

  6. Annualized Rate of Return • Calculate as a point of comparison. • What is the annualized rate of return if the deal closes in 3 months and you can buy shares at an average cost of $74? • That comes out to a 23% annualized rate of return. • Annualized return looks pretty good. • Market turmoil could be preventing this from trading closer to $78. Under usual merger circumstances, the spread would be much smaller, like $1-2.

  7. Meadow Valley Corp. (MVCO) • Private equity buyout at $11.25 per share. • Phoenix/Las Vegas area construction company. • Currently trading around $7-8 per share. • Big spread, which could be indicative of higher risk. • Construction has slowed considerably. • Private equity may have trouble securing financing. • Although financing seems to be secure, it’s hard to tell under what circumstances the buying party can cancel the deal.

  8. Where to Find More Information • SEC Filings • Proxy Filings: DEF 14A or PRE 14A • Contact the company’s investor relations department.

  9. Share Class Arbitrage • An attempt to profit from a discrepancy between the price spread between two different classes of shares. • Usually involves holding a long position in the undervalued shares class and a short position in the overvalued position. • Creates a hedged position that in theory eliminates the risk the underlying stock.

  10. Reminders on Short Selling • Borrowing shares you don’t own and selling them, hoping that the price of the stock goes down and you will be able to cover at a lower price and make a profit. • Requires a margin account and your broker must be able to find shares for you to borrow.

  11. MWA and MWA.B • Example where the board of directors approved a conversion of B shares into A shares. • Spread closed now. • Spread varied from close to 0 to 25% +

  12. CMG and CMG.B • Chipotle’s two share classes. • CMG trading around $49. • CMG.B trading around $43. • $6 spread. • Arbitrage profit if the share prices converge. • Historically, the share prices do converge and they could also merge the share classes in the future. • B shares have 10 times the voting rights of A shares, but B shares are somewhat less liquid and have no options.

  13. GEF and GEF.B • GEF trading around $37. • GEF.B trading around $30. • B shares are attributed 150% of the earnings and dividends of A shares. • Again, B shares are less liquid but hold ALL of the voting rights. • Management and family own a large proportion of B shares.

  14. Going Private Transactions • Essentially a “cash-out” for small shareholders. • A company can avoid the filing costs of being a public company by reducing its shareholder count below a certain number (usually 200). • To accomplish this, the company submits a proposal to a shareholder vote to buy back shares from any shareholder owning less than, say 500, shares at a given price. • These transactions are often completed by a reverse stock split immediately followed by a forward stock split.

  15. Shareholder of Record • Read proxies carefully because some companies may require shareholders to be shareholders of record in order to be eligible for the cash-out. • Shares held at brokerage firms are held in “street name.” • In order to become a registered shareholder, you must get physical stock certificates (and of course pay a fee to your broker). • These transactions are also subject to shareholder approval.

  16. Entrx Corp. (ENTX) • Going private by means of a cash-out of shareholders holding less than 500 shares. • Cash-out price of $0.35 per share. • Trading (or at least recently priced) around $0.20 per share. • Potential for a quick 75% gain, but only allows for an investment of $90-100. • That’s still a potential profit of around $70.

  17. Katy Industries (KATY) • Going private by cashing out shareholders holding less than 500 shares. • Cash-out price of $2 per share. • Currently trading at $1.1 per share. • Huge potential payout, but this one looks risky. • Lost $3.2 million this past quarter. • Could easily cancel the deal. • Financing may be difficult. • Consider potential losses if the deal falls through.

  18. Questions?

  19. Club Portfolio Update • Motion to buy $1,000 of Core-Mark (CORE) passed. • Order executed on 10/28 to purchase 52 shares at $19. • Total cost of the position was $995. • Current value (as of 11/7) was $949. • We still have $19,005 to work with!

  20. ccig.osu.edu

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