Merger arbitrage and the interaction betweentarget and bidder stocks during takeover bids

We use bivariate ARCH specifications to model the conditional mean and stock price volatilityfor 56 takeover bids from January 1985 and July 1994. Using daily data from one year prior to thetakeover announcement until the conclusion of the bid, we allow for two-way interaction in bothmoments between the bidding and the target companies.We find a significant departure from relationto the market for target stocks after a takeover announcement, but not for bidders. These results haveimplications for merger arbitrage, and we suggest a technique for controlling for differential betas inthe merger arbitrage portfolio. Interaction between bidder and target stocks is strong for stock-swapand mixed cases, where the bid price is transferred from bidder to target. But we also find someinteraction in cash bids, and from target to bidder in stock-swap takeovers. We argue that this can beexplained by both bidder and target reflecting the likelihood of success of the takeover offer.