Behavioural Factors in Risk Arbitrage

In the context of takeovers, this paper examines the trading behavior of investors around a salient reference point, the 52-week high, and its effect on asset prices. Using a large sample of institutional trade-level data the paper documents a 50% increase in institutional investor exit at the announcement date for offer prices exceeding the 52- week high. The increased selling pressure leads to significant stock price underreaction and explains a large part of the returns in risk arbitrage. A risk arbitrage strategy exploiting the underreaction generates annual alphas of up to 11.9% with a sharpe ratio of 1.63 in the US and in a large sample of over 7000 international takeover transactions. Consistent with limits to arbitrage, the trading strategy's profits vary negatively with the available capital in the arbitrage sector. I rule out several alternative explanations for my results and finally, using trading costs estimated from institutional trade-level data and a parametric portfolio policy approach, the paper demonstrates the economic significance of the effect controlling for other behavioral and rational return predictors in risk arbitrage.

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