Hedging Cash vs Stock Deals

A merger arbitrage position isn't just "buy the target." What you actually buy — and what, if anything, you hedge — depends entirely on how the deal pays target shareholders. A cash deal converts cleanly to a fixed dollar amount at close, with no acquirer exposure at all. A stock deal instead pays target shareholders in acquirer shares, which means the value of the deal itself moves with the acquirer's stock price, and the position has to be hedged against that.

Why the hedge differs

In a cash deal, the payoff at close is a known number — $50 a share, say — regardless of what happens to any other stock. Owning the target is the whole trade; there is nothing else to hedge against, because nothing else affects the payout. In a stock deal, target shareholders instead receive a fixed number of acquirer shares per target share (the exchange ratio) — say 0.75 acquirer shares for each target share. The target's fair value, once the deal is priced in, is simply that ratio times the acquirer's current price, so it rises and falls with the acquirer's stock even before the deal closes. A merger-arb desk that only owns the target in a stock deal is unintentionally long the acquirer too; shorting acquirer shares in the exchange ratio strips that exposure back out, leaving a position that profits purely from the deal spread closing.

Worked example

Acquirer offers 0.75 of its own shares for each target share, and the acquirer trades at $80, putting deal value at 0.75 \times 80 = \60 per target share. The target trades at \57, a $3 spread. A desk buys 100,000 target shares and shorts $0.75 \times 100{,}000 = 75{,}000$ acquirer shares. If the acquirer's stock rises to $84 before close, deal value rises to $63 — but the short acquirer position loses exactly enough to offset that rise, so the position's P&L still tracks only the $3 spread narrowing to zero at close, not the acquirer's own move.

What this means in practice

Many deals are a mix — part cash, part stock — and the hedge should mirror that mix exactly: hedge the stock-financed portion with a short in the acquirer sized to that portion's exchange ratio, and leave the cash-financed portion unhedged, since it carries no acquirer exposure to offset.