Every concept, endless questions
Each concept is a small financial model. Read how it works, then draw a real interview question from it: forwards, backwards or what-if, with fresh numbers and a worked solution every time.
Forward runs a concept the usual way. Inverse runs it backwards, which is what separates understanding from memorizing.
Event-Driven
4 conceptsMerger arbitrage spread
When a deal is announced the target does not jump all the way to the offer. The gap that remains — the spread — is what the market charges for the chance the deal breaks and for the wait until it closes. Buy the target, collect the spread at closing; that is the trade. Judged on its own the spread looks small, so arbs annualize it: a 3% spread over four months is 9% a year. In a stock deal the payment is acquirer shares, so the arb shorts the acquirer in the exchange ratio to lock the spread in and take the acquirer’s price out of the bet. Either way the arb is selling insurance against the deal failing, and the spread is the premium.
Deal break price
The spread is what you earn if the deal closes; the break price is what you are left holding if it does not. Start from where the stock traded before the deal leaked, move it with the sector since — the world has changed in the meantime — and take something off for the damage: a company that was for sale and was not bought is worth less than one that never was. The gap from today’s price down to that number is the downside; the gap up to the offer is the upside. Merger arb is the business of comparing the two and deciding whether the odds the market implies are the odds you believe.
Probability-weighted expected value
A merger arb position is a bet with two outcomes and known payoffs, so it can be priced like one. Weight the offer by the chance the deal closes and the break price by the chance it does not, and you have the expected value of the stock. Set that equal to the market price and solve, and you have the probability the market is implying — the number every arb compares with their own. If you think the deal is more likely to close than the price says, you are being paid to take the position; if less, you are not, however wide the spread looks. Add a third outcome — a bumped offer — and the same arithmetic tells you what a competing bid is worth.
Rights issue dilution
A rights issue sells new shares to existing holders at a discount. The discount is not a gift: after the issue every share, old and new, is worth the same blended price — the theoretical ex-rights price — which sits between the old price and the subscription price. A holder who takes up their rights ends up with more shares at that lower price and is exactly as wealthy as before; one who sells the rights pockets their value and is also exactly as wealthy as before. The only way to lose is to do nothing. What the issue does change is the company: more shares, more cash, less debt — and that, not the headline discount, is what the event-driven investor is pricing.