Rick arbitrage : analysis and trading systems

In this thesis we quantify the risk arbitrage investment process and create trading strategies that generate positive risk-adjusted returns. We use a sample of 895 stock swap mergers, cash mergers, and cash tender offers during 1998-2004Q2. We test the market efficiency hypothesis, and after accounting for transaction costs, we find that our risk arbitrage strategies generate annual risk-adjusted returns in excess of 4.5%. The research also obtains various other merger statistics, and relates them to a variety of economic indicators and merger timing models, as described in past work. We also estimate conditional probabilities of a merger's success, using a deal characteristic-driven prediction model, and combine it with market-implied probabilities. Our analysis suggests that the probability of success of a merger depends on a deal's characteristics. Further, it implies that one can improve on the market-implied estimates thereby creating trading opportunities. The analytical results achieved in this thesis can be used as the foundation for building an effective risk arbitrage trading platform.