Risk-Reward Ratio of the ARM Holdings-Softbank Merger



Scenario analysis 

In the risk arbitrage world, an 8% expected return usually indicates a medium-risk transaction. Usually, the spread wouldn’t be trading so tight. Professional arbitrageurs have been licking their wounds lately after the breakup of deals like Pfizer-Allergan, Baker Hughes-Halliburton, and Staples-Office Depot. When strategies like merger arbitrage have bad months, hedge funds and fund of funds allocate capital out of that strategy into other strategies. This causes spreads to widen as arbitrageurs reduce their exposure.

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Downside if the deal breaks

ARM Holdings (ARMH) was trading at about $47 per share before the deal with Softbank was announced. If the deal breaks, does the stock price return to those levels? That’s probably a decent bet, depending on the reason for the break. Note that it’s much harder for United Kingdom companies to back out of transactions than it is for US companies.

Take a look at the above chart and imagine that you’re short the spread, which is trading at $1.52. If the deal closes as advertised, you’ll make your $1.52. If the deal breaks, the spread will blow out to $20.00. So, your potential return is $1.52 and your risk is $18.5 ($20.00 – $1.52). The risk-reward ratio is about 12:1. This is a decent ratio for risk arb deals.

Merger arbitrage resources

Other important merger spreads include the deal between Cigna (CI) and Anthem (ANTM) and KLA-Tencor (KLAC) and Lam Research (LRCX). For a primer on risk arbitrage investing, read Merger Arbitrage Must-Knows: A Key Guide for Investors.

Investors who are interested in trading in the tech sector can look at the iShares Global Technology ETF (IXN).


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