Chapter 1
Introduction to Merger Arbitrage

Arbitrage is one of the oldest forms of commercial activity. One of the earliest published definitions of the term arbitrage can be found in Wyndham Beaves's seminal Lex Mercatoria,1 first published in 1685, which trained several generations of European merchants until its last edition of 1803. One will be hard pressed to find a finance book today that has been in print for over a century. In the 1734 edition, Beaves writes about arbitrage:

ARBITRATION (a Construction of the French Word Arbitrage) in Exchanges has been variously defined by the several Authors who have treated of it.

One says it is a Combination or Conjunction made of many Exchanges, to find Out what Place is the most advantageous to remit or draw on.

Another describes it, by saying it is only the Foresight of a considerable Advantage which a Merchant shall receive from a Remis or Draught, made on one Place preferably to another.

A third construes it to be a Truck which two Bankers mutually make of their Bills upon different Parts, at a conditional Price and Course of Exchange.

According to a fourth, it is the Negociation of a Sum in Exchange, once or oftener repeated, on which a Person does not determine till after having examined by several Rules which Method will turn best to Account.

Lex Mercatoria, 1734, p. 387

Around that time also appeared in Basel the first book dedicated to arbitrage, J. Wiertz's 1725 oeuvre Traite des Arbitrages de Change,2 which discusses various calculation methods to convert one currency into another. All of these early forms of arbitrage involved currency arbitrage. Patrick Kelly describes a typical nineteenth-century arbitrage in his 1811 book The Universal Cambist, and Commercial Instructor: Being a General Treatise on Exchange, Including the Monies, Coins, Weights and Measures of All Trading Nations and Their Colonies: with an Account of Their Banks and Paper Currencies,3 which took over from Beaves's Lex Mercatoria as the obligatory text book for merchants in the nineteenth century:

Arbitration of Exchange

Arbitration of Exchange is a comparison between the course of exchange of several places, in order to ascertain the most advantageous method of drawing or remitting Bills. It is distinguished into simple and compound arbitration: the former comprehends the exchanges of three places only, and the latter of more than three places.

Simple Arbitration

Is a comparison between the exchanges of two places with respect to a third-that is to say, it is a method of finding such a rate of exchange between two places as shall be in proportion with the rates quoted between each of them and a third place. The exchange thus determined is called the Arbitrated Price, and also Proportional Exchange.

If, for example, the course between London and Paris be 24 Francs for £1 sterling, and between Paris and Amsterdam 54d. Flemish for 3 Francs, (that is, 36s. Flemish for 24 Francs,) the arbitrated price between London and Amsterdam through Paris, is evidently 36s. Flemish for £1 sterling: for as 3 Fr. : 54d. Flem. :: 24 Fr. : 36s. Flem.

Now, when the actual or direct price (as seen by a quotation of otherwise advised) is found to differ from the arbitrated price, advantage may be made by drawing or remitting indirectly; that is, by drawing on one place through another, as on Amsterdam through Paris; [.]

To exemplify this by familiar illustrations, suppose the arbitrated price between London and Amsterdam to be, as before stated, 36s. Flemish for £1 sterling; and suppose the direct course, as given in Lloyd's list, to be 37s. Flemish, then London, by drawing directly on Amsterdam, must give 37s. Flemish for £1 sterling; whereas, by drawing through Paris he will give only 36s. Flemish for £1 sterling; it is, therefore, the interest of London to draw indirectly on Amsterdam through Paris.

As securities markets began to develop and expand globally during the nineteenth century, arbitrage began to expand beyond simple currency exchanges. This is reflected in how Otto Swoboda expands the definition of arbitrage in his book Börse und Actien, first published in Cologne in the year 1869:4

Under arbitrage, that is decision, we understand the comparison of notations of any one place with those of another in order to use any arising difference, relative to exchange rates as well as security quotes, and thereby those who enter into such arbitrages (bring together) differences in prices between to places in their favor. [.] Early arbitrages occurred only in exchange rates, and only when a merchant owed another in a different location a certain amount or had a claim. He would then compare quotations in different places to see in which it would be most favorable to cover the debt or cover the claim. Only later a trade of its own developed from this, so that even without preceeding commerce a speculation in currencies or funds was effected.

The analysis of n-grams of books digitized by Google in Figure 1.1 shows the occurrence of the term arbitrage in printed books over time. In the early days of book printing, arbitrage appears to have been used frequently. However, it is the comparatively small number of books in print then that inflates the relative use of this term.

Figure 1.1 Frequency of the Occurrence of the Term Arbitrage in Printed Books

It is not until another century later, the 1960s, that merger arbitrage first appears in print, followed by risk arbitrage a few years later. The analysis of n-grams in Figure 1.2 shows the explosive growth of the usage of these terms since then. It is no surprise that the late 1960s gave rise to growing interest in arbitraging mergers, as this coincided with a wave of aggressive merger activity in England and the United States, which led to the adoption of many laws still in place today, such as the City Code. This will be discussed in more detail later. While risk arbitrage dominated as a description of the strategy discussed in this book for many years, merger arbitrage became more popular as a term in the late 1990s, and has surpassed risk arbitrage as the dominant term since the year 2005.

Figure 1.2 Frequency of the Occurrence of the Terms Merger Arbitrage and Risk Arbitrage in Books

Unfortunately, the early descriptions of arbitrage are echoed in many modern-day definitions. Merriam-Webster's 11th Collegiate Dictionary defines it as:[

1. The nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies
2. The purchase of the stock of a takeover target especially with a view to selling it profitably to the raider

While the second definition in Merriam-Webster relates to the subject matter at hand in this book, both definitions fail to capture all the different facets and breadth of arbitrage properly. In a world of instant global communications, the first type of arbitrage is rarely viable. A much better definition of arbitrage is that used by economists, who define arbitrage as a "free lunch": an investment strategy that generates a risk-free profit. Academic finance theory formalizes this definition as a self-financing trading strategy that generates a positive return without risk. Three different degrees of arbitrage can be distinguished, as shown in Table 1.1.

Table 1.1 Orders of Arbitrage

Source: Nassim Taleb, Dynamic Hedging: Managing Vanilla and Exotic Options (New York: John Wiley & Sons, Inc., 1997). Reprinted with permission of John Wiley & Sons, Inc.

A simple location arbitrage in commodities would be the purchase of crude oil in Rotterdam, the rental of a tanker, and the simultaneous resale of the oil in New York. Today, most arbitrage activity occurs in financial markets. An arbitrageur might take positions in a currency spot rate, forward rate, and two interest rates. Arbitrage transactions of this type are known as cash-and-carry arbitrage. This type of arbitrage can be understood easily as the purchase of oil and the simultaneous sale of...