Merger Arbitrage

*I generally don't post about specific stocks, but I haven't gotten around to some of the research I meant to do and something I am looking at is increasingly looking worthwhile.

Merger arbitrage is the art of buying companies that are getting acquired and selling companies that are acquiring. When the merger goes through, you collect the spread between them. If the merger doesn't go through, the spread widens and you lose money.

Alpha Natural Resources (ANR) is a coal stock and Cleveland-Cliffs (CLF) is an iron and coal stock. Cleveland-Cliffs announced on July 15th that it will purchase ANR for $22.23 and .95 shares of CLF. On the 16th, ANR opened up around 119 after trading around 95 the past few days and then proceeded to tank back down to a close of around 96 at the close of the 17th. CLF was trading around 110 prior to the announcement and has come down to about 97.25.

Based on current prices, 100 shares of ANR should be worth 22.23*100+97.25*95=$11,462 and only cost $9,580 on the market. Since the value of the ANR is dependent on the value of CLF, you would sell short the CLF in a merger arb situation. This way when you receive the 95 shares of CLF you can deliver them to whomever you borrowed the stock from.

For example, assuming the existing prices are where you buy and short and the merger closes, that means that ANR will be priced such that what you can buy equals 22.23*100+p*95, where p is the price of CLF. If CLF closes out at 100, ANR should be worth 117.23 per share. After your ANR shares are converted to CLF, you can close out your short (worth 95*100 dollars) and keep 2223 (22.23*100). The merger is supposed to complete at the end of the year and depending on how your margin account is handled, it looks like you could put up about 20k for an annualized return of about 20%.

That's not to say that this isn't risky. Merger arbitrage is a very risky business and it admittedly isn't mine. Given how that ANR has fallen fairly significantly since the announcement came out, the market is pricing (excluding shorting costs and TVM) that the stock is only worth three-quarters a share of CLF. I will be waiting for more details, particularly the proxy. Do your homework and certainly don't blindly follow me. I would have bought it on the open of 7/16 and have lost like 20 dollars a share already on ANR and not made it back on CLF. At these prices and this spread, I feel like it would be less risky given the potential gain.

SEC 8-K form
Press Release

edit: Harbinger Capital increased a position from 3/31 of about 8.73% to about 18.36% and announced in a 13D that they would oppose the merger.

News from the front

I'm honestly amazed by Hank Paulson. He has been going around to the press since mid-January and has been talking about the risks to the economy. According to the Guardian, Paulson has said, "I still believe that we are going to continue to grow, although at a slower pace for a while, but the risk is very much to the downside and the risks are primarily housing." This would have been something to have said like 8 months ago or maybe a year and a half ago when housing started showing its decline. More than that, though, I'm curious as to how he thinks about risk. He's obviously not thinking about standard deviation, a traditional measure of how risky an asset is. Standard deviation is not biased to one side or another it is a statistical fact (he might have meant that these figures are increasing, but then he should have said risk is increasing). Furthermore, Value at Risk or the size of losses in worst case scenarios could not be what he is thinking of since they are necessarily always concerned with the downside. I guess I use a pretty common-people conception of risk that is different from Paulson's. There's really no one definition of risk, but courtesy of Frank Knight I know that risk is quantifiable. I know that risk is somehow related to the probability of a loss (or downside deviation from the mean) and the size of that loss. But I'm just not sure how risk could ever not be on the downside. I'm pretty sure that he's not talking about risk, but he is talking about where he thinks the economy in general will be going and saying risks are on the downside (repeatedly to the media) for pure rhetorical reasons.

The Economic Stimulus plan passed Congress last night. I'm pretty sure I'm going to receive some money. I'm pretty sure that it's going to be bad for this country. I'm pretty sure I'm still going to cash the check anyway.

Antitrust regulators are also going after the Nymex/CME deal. The Justice Department is opposed to having the financial futures exchanges controlling or owning their own clearing operations. Typically, antitrust regulators are sticking up for the consumers who get fleeced by prices too high. Most futures contracts have notional values in the hundreds of thousands of dollars and a lot of good brokerage firms don't let you open a futures trading account without sufficient experience. These markets have fierce competition and the people who participate in them have ample means to compete with any exchange if they wanted to. There are plenty of markets where they just block trade equities. It is absurd if the market is just defined as the futures exchanges. Any exchange or ECN could compete in this market and any Investment Bank could start their own if the structure were really fleecing them.

Great opinion piece in the WSJ about McCain's VEEP options. I've heard abunch about Mark Sanford from South Carolina (who would be much better for the economy as President than any of the frontrunners) and I'm glad WSJ put him on their short list. I'm just concerned if he might be too principled for McCain. Sanford could at least run in 2012 by himself.