What is risk arbitrage?
A speculative investment strategy normally adopted by hedge funds rather than individual traders.
Also called merger arbitrage trading, it involves buying and selling the stocks of two merging companies at the same time. Stock in the business being acquired is bought, while stock in the acquiring firm is sold.
Where have you heard about risk arbitrage?
The term isn't widely used by everyday investors. But you may see it mentioned in reports of high-profile merger deals, which have a significant influence on the share price of a company or companies.
What you need to know about risk arbitrage...
As part of a proposed merger, an acquiring firm may offer to buy shares in the target company at a premium to their current price (e.g. a 20% premium). This generally causes a flurry of interest in the target company's shares, pushing their price upwards.
However, because there's still a risk that the deal won't go through, shares in the target company are unlikely to rise quite as high as the price being offered by the acquiring firm.
A risk arbitrage trader would buy shares in the target company while they're below the offer price. Then, once the merger deal goes through, they'd be able to sell them at the higher offer price therefore making a profit.
But there's a catch: if the merger deal collapsed and the share price of the target company dropped significantly, the trader would make a loss.