Wednesday, October 22, 2008 0 comments ++[ CLICK TO COMMENT ]++

Currencies Can Make Or Break Risk Arbitrage

If you are doing risk arbitrage, you need to be careful with currencies if you'll be receiving compensation in foreign currencies or foreign shares. Professionals will hedge the currencies but small investors often can't afford to do so.

I'm located in Canada so changes in US$ vs C$ can wipe out all my gains. Anyone following my investment "career" :) will recall how I lost money in C$ terms on my US bond position last year even though it posted positive gains in US$. This wasn't a risk arbitrage position but the problem is very acute for risk arbitrage since the gap you are working with tends to be small and you have no chance of waiting to recoup.

The following graphic depicts two takeover deals I have mentioned on this blog: BCE and Fording Canadian Coal Trust. In the BCE deal, shareholders will be paid a fixed amount in Canadian dollars. In contrast, the Fording deal involves receiving a fixed US$ amount (along with a small stake in Teck Caminco.)

You'll notice that there is a 15% gap (relative to late July.) This is almost the entire profit potential in these deals (unless you bought during a huge plunge in the shares, or at some other time period.) In this case, the Canadian dollar declined significantly--this was a massive move for a currency and quite unusual--so Americans getting paid in Canadian dollars would see their profit reduced. For instance, American risk arbitrageurs on the BCE deal will end up worse than they probably thought back in July. Of course, this is just one slice of time. Canadian dollar strengthened last year so it depends the situation would have been opposite. The point, though, is that M&A involving foreign currencies is kind of risky.


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