What is Risk Arbitrage?

Risk arbitrage, as the name suggests, is the arbitrage process which involves risk. Risk arbitrage differs considerably from market arbitrage, which is rare, risk-free and market maker friendly. Risk arbitrage is widely practiced by retail traders and market makers. Although it involves risk, the practice is still considered as a low-risk trading strategy.

There are 3 main risk arbitrage strategies available for retail traders,

1. Merger and Takeover arbitrage.
2. Liquidation arbitrage.
3. Pairs trading arbitrage.

Merger and takeover arbitrage is the most common risk arbitrage strategy in which the traders locate and trade undervalued stocks of companies, which are merged to or are being acquired by other company. The process requires quick response to news, and thus favors traders with Level II access.

Liquidation arbitrage exploits the price difference between current stock price of a company and its estimated liquidation value. The process involves estimating the company’s liquidation assets value.

Pairs trading arbitrage or relative-value arbitrage is less common. It includes finding a stock pair with good correlation. Traders wait for divergence from the correlation and take appropriate positions (long or short) according to it. Traders are profited when the pair returns to original higher correlation.
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