Cross Sectional Variation in Risk Arbitrage

In this study, we are interested in understanding the price formation process of bidders' and targets' shares after the merger announcement and seek to explore the impacts of liquidity risk, price pressure, and limited arbitrage theory on the cross sectional variation in risk arbitrage. Using a sample of 1046 merger offers and regression technique, we find that arbitrage spread is positively correlated with deal completion risk, positively correlated with liquidity risk in a concave way: arbitrage spread increases at a decreasing speed as the liquidity risk increases. This finding is consistent with the literature on stock returns. We also find that price pressure is significant in determining arbitrage spread. However, we fail to find evidence that is consistent with the limited arbitrage theory: limitation on the supply of arbitrage capital is not significantly correlated with the deviation of arbitrage spread, in either direction, from the efficient level. The risk factors and limits of arbitrage identified in the paper help explain the profits and cross sectional variation in risk arbitrage