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Lecture 10

FINE 434 Lecture Notes - Risk Premium, United States Treasury Security, Capital Asset Pricing Model
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Department
Finance
Course Code
FINE 434
Professor
Jiro Kondo

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Real option synergies
Real option synergies depend on some triggering event to produce a payoff.
Some examples:
- Growth option synergies:
o E.g., R&D, access to network.
- Exit option synergies:
o Arise from increased flexibility in altering investment strategies.
Estimating synergy value
Valuation of synergies in place happens with DCF method:
  
Some rules of thumb for synergy valuation:
- Establish credibility of the synergy source.
- Everything after tax.
- Use a terminal value to reflect extended synergy life:
 
 
Concluding remarks
Not all synergies are created equal.
Synergies are:
- Highest in horizontal deals.
- Middling in vertical combinations.
- Lowest in conglomerate deals.
Apply rigorous analysis and adopt a critical attitude.
Communication towards investors is very important.
Topic 10: Merger Arbitrage
Short selling: Definition
The selling of a security that the seller does not own, or any sale completed by the delivery of a
security borrowed by the seller.
Short sellers assume that they will be able to buy the stock at a lower price than the price at
which they sold short.
This is an advanced trading strategy, with many unique risks and pitfalls. Novice investors are
advised to avoid short sales.
Short selling is done for two reasons:
- Hedging.
- Speculation.
Short selling: Players
Short sellers tend to be highly informed (i.e., they are capable of identifying overvalued stocks).
Players include:
- Wealthy individuals.
- Hedge funds.
- Large institutions.
- Day traders.
Short selling: Terminology
Short interest: The total number of shares of a security that have been sold short.
Short covering: Purchasing securities in order to close an open short position. This is done by
buying the same type and number of securities that were sold short.
Short squeeze: A situation in which a lack of supply and/or an excess demand for a traded stoc
forces the price upward.
Short selling: Pro or contra?
It is safe to say that short sellers are not the most popular people on Wall Street.
Many people consider short selling to be unethical.
Short selling indeed has a dark side (short and distort strategy).
However, short selling is in general very useful:
- Provide liquidity.
- Identify overvalued stocks.

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Description
Real option synergies Real option synergies depend on some triggering event to produce a payoff. Some examples: - Growth option synergies: o E.g., R&D, access to network. - Exit option synergies: o Arise from increased flexibility in altering investment strategies. Estimating synergy value Valuation of synergies in place happens with DCF method: 𝐶𝐹 𝑡 𝑉𝑠𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒 ∑ (1 + 𝐾 )𝑡 Some rules of thumb for synergy valuation: - Establish credibility of the synergy source. - Everything after tax. - Use a terminal value to reflect extended synergy life: 𝐶𝐹(1 + 𝑔 )∞ 𝑇𝑉 = 𝐾 − 𝑔 ∞ Concluding remarks Not all synergies are created equal. Synergies are: - Highest in horizontal deals. - Middling in vertical combinations. - Lowest in conglomerate deals. Apply rigorous analysis and adopt a critical attitude. Communication towards investors is very important. Topic 10: Merger Arbitrage Short selling: Definition The selling of a security that the seller does not own, or any sale completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower price than the price at which they sold short. This is an advanced trading strategy, with many unique risks and pitfalls. Novice investors are advised to avoid short sales. Short selling is done for two reasons: - Hedging. - Speculation. Short selling: Players Short sellers tend to be highly informed (i.e., they are capable of identifying overvalued stocks). Players include: - Wealthy individuals. - Hedge funds. - Large institutions. - Day traders. Short selling: Terminology Short interest: The total number of shares of a security that have been sold short. Short covering: Purchasing securities in order to close an open short position. This is done by buying the same type and number of securities that were sold short. Short squeeze: A situation in which a lack of supply and/or an excess demand for a traded stoc forces the price upward. Short selling: Pro or contra? It is safe to say that short sellers are not the most popular people on Wall Street. Many people consider short selling to be unethical. Short selling indeed has a dark side (short and distort strategy). However, short selling is in general very useful: - Provide liquidity. - Identify overvalued stocks. - Make markets more efficient. - Voice of reason in bull markets. Short selling certainly draws a lot of media attention. Merger arbitrage: Characteristics Merger arbitrage: Involves the purchase of a target’s stock right after merger announcement. Target’s stock price (post-announcement) typically trades at a 1-2% discount (or deal spread) to the offer of the bidder (due to time value of money and possibility that deal fails). Merger arbitrageurs: - Evaluate deal spread, calculate annual return. - Estimate probability of deal failure. - If spread is sufficiently large: o Purchase shares in target firm. o Short acquirer’s stock (only for stock mergers to eliminate market risk). Several characteristics of M&A activity are important for understanding merger arbitrage: - Merger agreements sometimes fall apart. - Merger failure is idiosyncratic, but sometimes due to aggregate market conditions. - Form of payment to target determines trades required to capture the arbitrage spread. Arbitrage is a zero-investment purchase of a security financed by the sale of an identical security at a higher price. Not a form of true arbitrage: arbitrageurs make a risky investment. Merger arbitrage: Cash deals Most straightforward type of merger arbitrage. Sears offers $62 of Land’s End (LE). Price of LE prior to announcement: $51.02 (close of prior trading day). Price of LE immediately following announcement: $61.73. Promised return: net spread divided by cost of purchase. - $0.25/$61.73 = 0.405% Assessment of deal failure risk: low - Signed definitive agreement. - Friendly deal. - LE shareholders representing 55% of shares agreed to tender. - Both companies in good financial shape so deal financing would not be an issue. - Little chance of government blocking merger. Assume merger arbitrageur believes the probability of the deal not goi
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