Risk and Return Characteristics of Risk Arbitrage in Western Europe

Lise K. Kristensen & Charlotte B. J. Reventlow

Student thesis: Master thesis


Historically, the risk arbitrage literature has documented substantial abnormal returns in the US, the UK, Australia and Canada for the seemingly market neutral risk arbitrage strategy. However, some recent literature has questioned and rejected market neutrality and even finds evidence indicating a non-linear relationship between excess risk arbitrage returns and excess market returns. The combination of rapid capital inflows into hedge funds, the large abnormal returns and the question of market neutrality motivates a study of the risk and return characteristics of risk arbitrage in Western Europe. Using a sample of 2167 Western European stock and cash transactions during 1990-2015, we analyze the risk and return characteristics of risk arbitrage. First, we benchmark the risk arbitrage returns against linear and non-linear asset pricing models. Further, we examine the impact of portfolio construction and discuss quantitative arbitrage investing vis-a-vis discretionary portfolio selection. Moreover, in order to examine the potential of developing an optimal exit timing strategy, we conduct an autocorrelation analysis. Finally, we discuss the implications of the results for practitioners. While we find risk arbitrage to earn abnormal returns, the trend appears to be decreasing over time. Further, we find that risk arbitrage is not a market neutral strategy, which is predominantly driven by the characteristics of cash transactions. The abnormal returns are robust to the portfolio construction approach, asset pricing models, diversification constraints and constant transaction costs. Finally, we find potential for the development of an optimal exit timing strategy. The results lead to the following implications for practitioners. First, despite the abnormal returns, risk arbitrage is not an entirely market neutral strategy. Hence, in order to achieve market neutrality, practitioners should actively short the market. Second, practitioners should consider the portfolio construction approach, as it impacts the risk and return characteristics. Third, practitioners should consider developing an optimal exit strategy in order to decrease completion risk and increase abnormal returns.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
Publication date2016
Number of pages125