Question #33

If Cohen has established a USD 10,000,000 long position in SMA, then they have bought USD 10,000,000 / USD 25 = 400,000 shares in SMA post/after deal announcement. For each one of these SMA shares, they will receive 0.5 shares of BIG if the deal goes through, which sets the size of the short position in BIG as follows: Number of BIG shares to short = 0.5 × 400,000 = 200,000. Short proceeds raised from short selling 200,000 shares of BIG at a price of USD 52 = USD 10,400,000. If the deal goes through the short position in BIG, it can be covered by the BIG shares received in exchange for the long potion in SMA. This leaves the fund with profits of short proceeds – investment in SMA shares = USD 10,400,000 – USD 10,000,000 = USD 400,000. Should the deal fail, then, assuming prices revert to the pre-deal announcement level, the following occur: The loss from a long position in SMA = 400,000 × (USD 25 – USD 23) = USD 800,000. The loss from a short position in BIG = 200,000 × (USD 54 – USD 52) = USD 400,000. Total loss = USD 800,000 + USD 400,000 = USD 1,200,000. Hence, the ratio of potential losses to potential gains = USD 1,200,000 / USD 400,000 = 3x.