Forget kurtosis, leptokurtosis and platykurtosis. The best risk arbitrage trading strategy to use during this credit crunch is guts.For the first time in years, merger arbs have a chance of making money.
Before the market turmoil, it wasn’t worth placing a bet on a leveraged buy-out. Spreads were so tight that returns weren’t much better than banking the money.
Traders can now make a high double-digit return in a couple of months. Goldman Sachs estimates that buying 22 pending LBOs could generate an average annualised return of 36 per cent - if those deals go through. That’s alpha.
Take the battle for ABN Amro - the biggest deal going. Almost every hedge fund is playing it and some of the sums invested are staggering. One well-known City fund has at least $800m tied up in the deal. If it fails, hedge funds will be crucified.
But if the deal completes, it will be the biggest opportunity for arbs to profit since Vodafone’s hostile takeover of Mannesmann in 1999.
The spread on ABN - which widened to 20 per cent at the start of the crisis - is now about 11 per cent.
So why isn’t everyone doing it? Because they are terrified that three things could happen if credit markets become worse: a black hole in ABN; one of the investment banks underwriting the financing invokes a material adverse change clause; and regulatory intervention.
ABN was trading at about €34.50 on Friday - if these fears materialise and the bank bid collapses, the stock could halve. Losses would be catastrophic and the managers responsible will be pedalling to work on push bikes.
But if the biggest banking merger of all time goes through, some genius arb will be pulling up to the office in a different coloured Ferrari each day of the week, and risk arbitrage will have meaning again.