Question

Suppose the following stock prices for GE and Honeywell were observed before any talk of merger between the two institutions:

Honeywell (HON) 27.80

General Electric (GE) 53.98

Also, suppose you “know” somehow that GE will offer 1.055 GE shares for each Honeywell share

during any merger talks.

(a) What type of “arbitrage” position would you take to benefit from this news?

(b) Do you need to deposit any of your funds to take this position?

(c) Do you need to and can you borrow funds for this position?

(d) Is this a true arbitrage in the academic sense of the word?

(e) What (if any) risks are you taking?

Answer 1

Solution:

Given,

HON: 27.8

GE: 53.98

We know the price at will future merger transaction will happen HON = 1.055GE = 1.055x53.98= 56.95

(A) To take the benefit from this news we will take long position in HON stock in spot market as we know with certainty that we can earn profit by selling this stock at higher price of 1.055GE or 56.95.

(B) We need to deposit our funds to take this position as this is a long position and it requires us to deposit margin money with the broker.

(C) Yes we need to borrow funds as we have to pay the margin money and we can borrow funds at risk free rate as we know with certainty that we will be earning the higher profits in future without taking any risk. So, we can easily payoff the loan and still earn profit from this transaction.

(D) No this is not true arbitrage in academic sense because here we are certain of the future profit because of the knowledge of some private future information. But true arbitrage is when there failure to law of one price that is when two assets with same underlying risks or with same cash flows trade at different price. Another arbitrage opportunity is when an asset trade at different price than its true intrinsic value so that we can either earn risk free rate without investing any money or earn higher than risk free rate with taking any risk.

(E) Risk that we are taking is that there is possibility that the price of GE stock falls at the time of finalisation of this deal and hence the absolute price of the merger transaction in dollars term maybe lower than what we are expecting. Another risk is if this deal doesn't materialize due to some regulatory or any other issue.