The Arbitrage Fund has graciously allowed us to reprint this
article which appeared in their Quarterly Update.
Interest rates are going up. How soon, and how much is far from
certain. Unlike most other types of managers, rising interest rates
are good news. Here is why: Risk arbitrage spreads, the profit the
Fund earns on any particular transaction, tend to track the risk free
rate as measured by short term Treasury bills. Typically, an investor
will consider the time a transaction will take to close and the risk
of the transaction not closing, and assign a risk premium to it.
The result of this analysis is that an investor will demand that
the annualized spread be higher than the risk free rate. Therefore,
all else being equal, the higher the risk free rate is, the wider
risk arbitrage spreads are likely to be. When spreads are wider, the
absolute profit potential of a risk arbitrage fund increases.
All else being equal, increased rates can also lead to increased
deal risks. For example, it may be more difficult, or certainly more
expensive, to finance a transaction, particularly an all cash
transaction. If increased rates stifle growth, this can lead to a
"material adverse change" at a target company, a standard
out clause in most deal contracts. Widening of spreads in existing
deals is also an issue. Overall, however, the prospect of higher
rates should lead to higher returns in the risk arbitrage space,
something quite different from most other strategies.
