Merger arbitrage, or merger arb, is a type of event driven hedge fund strategy. Merger arbitrage hedge funds seek to profit from pricing discrepancies around the mergers and acquisitions of public companies.
Typically, in an all cash deal, where the stock of a company is being purchased for a fixed cash price, the merger arbitrage fund will buy the stock of the company that is being acquired after the deal had been announced. For an all stock deal or cash plus stock deal, in addition to buying the stock of the company being acquired, the merger arbitrage fund will often short the stock of the acquirer. While these are the most popular strategies, merger arbitrage funds may take short positions (short the company being acquired and/or long the acquirer), use equity options, enter into positions before a deal is announced, or employ various macro and factor hedges.
The price behavior of stocks involved in mergers and acquisitions can be very atypical. Standard risk models can severely mischaracterize the risk of merger arbitrage portfolios. Northstar Risk has risk models designed specifically for merger arbitrage strategies (read more here).