Three essays on risk arbitrage

Risk arbitrage is a strategy that seeks to profit from takeover offers by generally simultaneously purchasing and selling the shares of the merging companies. This dissertation consists of three essays that address three different issues related to risk arbitrage strategy: takeover success prediction, risk arbitrage for stock swap offers with collars and the determinants of risk arbitrage spreads. The first essay addresses methodology issues related to takeover success prediction modeling: case-control design vs. non-case-control design; logistic regression model vs. neural networks. The case-control design is shown to bias the intercept upward and, thus, tends to increase the estimated probability of failure, which will, in turn, result in a biased estimate of the expected return on each merger deal. Next, an adjustment to the probability estimates that removes the bias is explored. Second, neural networks is found to outperform logistic regression in predicting failed takeover attempts and performs as well as logistic regression in predicting successful takeover attempts. The second essay explores the risk and return characteristics of risk arbitrage strategy for a particular type of merger offers: stock swap offers with collars, utilizing an option type dynamic delta hedging strategy. A strong positive correlation in the risk return profile is found in a declining market and an insignificant correlation in a flat or rising market. This latter finding appears to be due to the increased probability of deal failure in market downturn. Contingent claims analysis shows a monthly abnormal return of 1.8%. The third essay studies the determinants of the cross sectional variation in risk arbitrage spreads and extends the literature by relating arbitrage spreads to transaction costs, supply of capital and price pressure. The empirical evidence shows that arbitrage spread is positively correlated with transaction costs. Limitation on the supply of arbitrage capital increases the deviation of the arbitrage spread, in either direction, from the efficient level. This finding is consistent with the limited arbitrage theory. Moreover, information costs dominate the selling pressure from the target shareholders in determining the arbitrage spread