Merger Arbitrage: Empirical Analysis of Abnormal Returns in the US Equity Market

Abstract

This thesis analyzes 3,198 merger and acquisition transactions in the United States from 1998-2020 to characterise the risk and return of risk arbitrage. Following this, the effects of portfolio construction, transaction costs, and return drivers are examined. The findings are compared with actual hedge fund returns. Results indicate that risk arbitrage has the potential to generate abnormal returns but that transaction cost management is critical to the performance. The abnormal returns are relatively stable over time and robust across a variety of portfolio construction approaches. While the theoretical portfolios constitute an adequate benchmark for actual hedge fund returns, hedge funds generally outperform them; potentially because of their active nature. Results suggest that the primary driver of persistent abnormal returns is completion risk, and more specifically the difference in payoffs between successful and unsuccessful transactions. Further, risk arbitrage returns appear to be mildly correlated with market returns across a broad range of market conditions and the relationship seems to be linear. The market dependence is primarily driven by the characteristics of cash transactions.