Advertisement
Canada markets open in 6 hours 53 minutes

  • S&P/TSX

    21,885.38
    +11.66 (+0.05%)
     

  • S&P 500

    5,048.42
    -23.21 (-0.46%)
     

  • DOW

    38,085.80
    -375.12 (-0.98%)
     

  • CAD/USD

    0.7331
    +0.0008 (+0.10%)
     

  • CRUDE OIL

    84.00
    +0.43 (+0.51%)
     

  • Bitcoin CAD

    87,799.12
    -8.98 (-0.01%)
     

  • CMC Crypto 200

    1,391.09
    -5.45 (-0.39%)
     

  • GOLD FUTURES

    2,351.00
    +8.50 (+0.36%)
     

  • RUSSELL 2000

    1,981.12
    -14.31 (-0.72%)
     

  • 10-Yr Bond

    4.7060
    +0.0540 (+1.16%)
     

  • NASDAQ futures

    17,770.75
    +203.25 (+1.16%)
     

  • VOLATILITY

    15.37
    -0.60 (-3.76%)
     

  • FTSE

    8,078.86
    +38.48 (+0.48%)
     

  • NIKKEI 225

    37,934.76
    +306.28 (+0.81%)
     

  • CAD/EUR

    0.6827
    +0.0006 (+0.09%)
     

The Risk-to-Reward Ratio of the Pharmacyclics–AbbVie Merger

Brent Nyitray, CFA, MBA

The Pharmacyclics–AbbVie Merger: The Risks and the Rewards (Part 5 of 12)

(Continued from Part 4)

Scenario analysis: A key part of merger arbitrage

We know that the annualized spread in the Pharmacyclics–AbbVie merger is about 6.2%, provided everything goes according to plan. In the risk arbitrage world, however, a 6.2% spread means a deal with some “hair” on it. The market is assigning some sort of probability that something can go wrong.

Generally speaking, your base-case assumption has to be that the deal closes as advertised and that you earn the spread. After all, a merger agreement is a contract. If AbbVie Inc. (ABBV) tries to walk away without a MAC (material adverse change) occurring, Pharmacyclics, Inc. (PCYC) could sue AbbVie and demand specific performance. In other words, Pharmacyclics could ask a judge to force AbbVie to complete the deal.

ADVERTISEMENT

What’s your downside if the deal breaks?

Before the deal, Pharmacyclics was trading at $235 per share. If the deal breaks, does the stock go back to that amount? Probably not. There have been press reports that Pharmacyclics is talking to people, and the company announced it’s seeking strategic alternatives. The stock was trading at around $175 a share when the discussions were leaked.

Look at the above graph and imagine that you’re short the spread. If the deal closes, the spread goes to zero, and you make about $4.50. However, if the deal breaks, you end up having to cover around $70. So, the risk-to-reward ratio is $70 down to $4.50 up. It’s a risk-to-reward ratio of 15:4. As a general rule, risk-to-reward ratios in the 15x to 20x range are typical.

Other merger arbitrage resources

Other important merger spreads include the deal between Hospira (HSP) and Pfizer (PFE). For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.

Investors who are interested in trading in the healthcare sector should look at the Health Care Select Sector SPDR Fund (XLV).

Continue to Part 6

Browse this series on Market Realist: