Abstract
Previous research documents that risk-arbitrageurs earn positive abnormal returns. However, this research treats the sum of two risks, deal risk and liquidity risk, as a measure of deal risk alone. We employ a forward looking measure of liquidity risk – the VIX – and we show that arbitrageurs’ ‘abnormal’ returns are higher when liquidity risk is higher. Thus, observed risk-arbitrage spreads compensate arbitrageurs for liquidity risk and deal failure risk. We conclude that the risk in risk-arbitrage has been systematically underestimated. Finally, we document an interaction between deal risk (a technical risk) and liquidity risk (a market risk) which is consistent with the analysis of real options models.
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