Applying the Teachings of Behavioural Finance to Risk Arbitrage Strategy

Abstract

Contrary to classic financial strategy based on the rational behaviour of economic agents, behavioural finance offers a more pragmatic vision of markets, notably by applying psychology.It is now fairly widely acknowledged that the assumption of market efficiency upon which classic financial strategy is based is not a good way to explain the operation of capital markets. Conversely, behavioural finance is able to furnish some very interesting answers by taking a fresh look at the decision-making process of investors. Many studies have thereby made the link between the forming of prices on equity markets and the behavioural biases of long only and long-short managers. Yet to our knowledge, there are no research papers that associate both behavioural finance and the alternative strategy of risk arbitrage.In this document, we therefore propose to apply the cognitive science approach to the study of this theory, which we have been using in our funds for more than 10 years. From the preparation of a M&A deal by a potential buyer to the establishment of the strategy in the portfolio by the arbitrageur, all the players on the chain are ideal subject matter for behavioural finance. Indeed, they share the same characteristic of having to make important decisions in an uncertain, probabilistic world that is saturated with information.To begin with, we present the general principles of behavioural finance by rounding up the scientific literature on the subject. In particular, we see how the main biases of financial market players are organised. We then go on to illustrate these biases with concrete examples drawn from the experience of our risk arbitrage management team. We conclude by showing that behavioural finance can be a precious tool in the management of a risk arbitrage portfolio.