I found this posting on the web, it is a decent explanation of risk arb...
Actually, the concept of risk arbitrage is very similar to expected value.
I. What is risk arbitrage?
On Wall Street, there are two types of arbitrage. The first type, which is commonly referred to as �classic arbitrage,� occurs when an instrument is incorrectly priced, causing a risk-free profit opportunity. For example, if a real life stock is trading at 60, and a call option with a strike price of 40 is trading at 15, a person could make a risk free profit by buying the options and shorting the stock until the prices corrected. This is the type of arbitrage that people refer to in HSX when they say that a stock is �arb.� If a movie has already grossed 40 million a week before delist, and the stock is trading at 38, everybody and their mother will post on TT that the stock is arb. (For more on classic arbitrage, see Tom Miller�s Cinemeconomists definitions).
Risk arbitrage takes classic arbitrage to the next level. A practitioner of risk arbitrage will take a situation with a finite number of outcomes, predict the likelihood of each outcome, and invest accordingly. For example, a risk arbitrageur in real life may be faced with a company�s vote on a merger. In this hypothetical, if the merger vote passes, the price of the stock will go up by 5 dollars per share. If the shareholders reject the merger, the price will go down by the same 5 dollars. The risk arbitrageur must determine the likelihood of each outcome and then decide whether to buy or short.
Risk arbitrage is a very important field on Wall Street. Robert Rubin ran the Risk Arbitrage desk at Goldman Sachs before he become CEO at Goldman and later, US Secretary of the Treasury.
II. Risk Arbitrage on the HSX
Most of HSX does not lend itself to risk arbitrage. The principles underlying predicting weekend openers are similar, but risk arbitrage focuses primarily on a finite number of specific outcomes, rather than open-ended speculation. Nonetheless, there are a few types of situations that lend themselves to risk arbitrage.
We had an interesting risk arbitrage opportunity in December. FANTA was getting ready to open, and we still had not heard from HSX about how they were going to calculate FANTA�s box office. There were three primary outcomes:
a. FANTA would not adjust, and would delist 12 weeks after it started on IMAX;
b. FANTA would adjust when it went wide, and would not include IMAX box office; or
c. FANTA would adjust when it went wide, and would include IMAX box office.
Under scenario (a), FANTA was a nuclear short, under (b) a close call but probably a hold, and under (c) a nice long-term hold for large ports. This scenario is not a perfect example, because even if you knew which way HSX would decide, you still had to predict the opening weekend determine the ROI.
(BTW, I believe that HSX made the wrong decision on FANTA, but that�s a subject for another day).
Some of the best situations for risk arbitrage on HSX come from similar rule interpretations. In addition, sometimes there is a situation where a studio has to make a decision, and there can be risk arbitrage opportunities there as well. The most common form of risk arbitrage, however, is in calculating bond adjustments.
III. Risk Arbitrage and Claire Danes
Two weeks ago, Claire Danes was on the calendar for adjustment for her performance in MONON. There were two possibilities: Either she would adjust, or she wouldn�t. (There was also a sub-possibility, as we shall see). This is the perfect scenario to apply risk arbitrage principles.
For the sake of simplicity in this example, I�m going to use round numbers and assume that ROI and commissions are not a factor. Also, it is important to note that the analysis I use contains my own presumptions. You may have totally different ideas about the likelihood of the CDANE adjust. Mileage may vary.
CDANE was trading at 1617. Our own DP Roberts calculated that CDANE would NOT adjust. AB Bond calculated that CDANE WOULD adjust, to 917. DP and AB posted their views on the bond board, and agreed to disagree.
To decide what to do based on the principles of risk arbitrage, a trader must ask two questions:
1) What is the relative likelihood that either DP or AB will be correct; and
2) What would be the investment result of either selection.
Looking at the first question, DP and AB agree most of the time. They are both very good at calculating bond adjustments, except that DP is better. (Actually, DP is good at everything - the guy is a force.). This is no slight on AB, who is a terrific trader and does an excellent job on bonds. In any case, I estimate that on the occasions when they disagree, DP is correct 80% of the time.
(Now an important disclaimer: DP himself does not believe that he is correct 80% of the time in which he and AB disagree. He actually proposed that I use a 50% number. Nonetheless, the 80% figure is more illustrative of how risk arbitrage works, so I will use it.)
Looking at the second question, let us assume that the trader shorts CDANE at 1619. If AB is right, CDANE will adjust down to 919, for a nice profit of 700. I have previously assigned this possibility a 20% likelihood.
If DP is right, then CDANE does not adjust. The investment result of the short is that lots of people cover their CDANE shorts and the price goes up. It is 50-50 whether I�ll be able to be on-line at the time of the adjust. (This is the sub-possibility referred to earlier). If I�m on-line at the time, I�ll lose 70 from other people covering and chuckage. If I�m not on-line, I�ll lose 140. So that means out of the 80% when DP is right, 40% would yield a loss of 70, and 40% would yield a loss of 140.
According to this analysis, if I shorted CDANE at 1619, there would be
a) a 20% chance of gaining 700;
b) a 40% chance of losing 70; and
c) a 40% chance of losing 140.
If you do the math, the short comes out to a prospective gain of 56. A risk arbitrageur that wasn�t concerned about ROI or commissions would always short CDANE in this scenario. I know I did.
CDANE did adjust to 919. AB was correct.
IV. Covering your short
Let�s say that everyone shorts CDANE, and the price starts to drop. At a certain point, it no longer makes sense to hold. You would want to cover when the prospective 20% gain was no greater than the 80% loss You can do the math, but I would have covered if CDANE had dropped to 1339. At 1339, there would be a 20% chance of gaining 420, a 40% chance of losing 70, and a 40% chance of losing 140. At this point, the investment is neutral.
V. Conclusion
There aren�t that many pure risk arbitrage opportunities in HSX. Nonetheless, the skills utilized in risk arbitrage are useful to other areas, such as portfolio construction and day-trading. Most of all, there are very few things more satisfying in HSX than working out a risk arbitrage scenario correctly.