ertainty, it is likely that the value ratio will be other than 2:1, and an investor employing the concept of arbitrage would make simultaneous contracts to buy shares in one of the two firms and to sell shares in the other firm. One of the effects of such simultaneous buying and selling would be to limit the amount of risk involved, should the merger not eventually occur.
In the situation described in the preceding illustration, it can be seen that it is also possible for an investor to make money through the application of arbitrage, for it is quite possible that the simultaneous buying and selling contracts would result in an outcome which would yield a profit in relation to the 2:1 ratio. It is also quite possible that the arrangements could result in a slight loss.
If simultaneous buy/sell contracts are entered into, held, and the merger eventually occurs, no gain or loss will occur, with the exception of transaction costs for the investor. If, on the other hand, the merger does not occur, the investor is still obligated by the simultaneous buy/sell contracts. Depending upon the action of the market upon learning that the merger will not occur, the investor will either make a profit or sustain a loss on the arbitrage contracts. It is also possible for an investor to enter into the simultaneous buy/sell contracts, and, during the interval prior to the ultimate decision on the merger, enter the market in the wake of the uncertainty, and make other con tracts on one or both of the two stocks, if current market prices offer an opportunity for profit. "The advantages associated with this type of activity make arbitrage situations well worth discovering and exploiting" (Alchian and Allen, 1990, 301).
Arbitrage activity, such as that described in the preceding discussion, "insures that any disparity will be quickly discovered; as arbitrageurs exploit such a disparity, prices will tend to move back into line as buying pre...