What's is the best way to hedge Wyeth/Pfizer deal with options?

Discussion in 'Options' started by nravo, Jan 26, 2009.

  1. nravo


    If you were doing a merger arbitrage to lock in a 12% profit how would you hedge? Deep ITM calls and puts on the, respectively long (Wyeth) and short (Pfizer)?
  2. It is a binary event. You can do the math on any of your options (ie just going long Wyeth outright, or selling strangles), but in all seriousness you are just as likely to make the same profit on capital by speculating in the direction of something.

    I bet if you buy some Feb ABX calls tommorow morning you'll likely make an easy 12% on your capital within 2 days time.

    Last I checked there was nothing to arbitrage. It is a cash deal.

    Although I view Rohm and Haas and Dow a different story (considering that deal happened during the biggest market/commodities crash since 1929), there is a high enough probability someone will have second thoughts on this pharm deal in this environment, enough to make you worry that the 15% winning (til the end of the year) may not be worth tying your capital up.
  3. nravo


    It's a cash deal? News to me.
  4. nravo


    What is the risk with long Wyeth (short DITM Wyeth Call) paired with Short Pfizer and short DITM Pfizer put)?
  5. rluser


    If you want to lock in an advantageous position why not use SSFs instead of options?
  6. nravo


    I'm not sure what the advantage would be, to be honest.
  7. There's no way to "lock in" a 12% profit since there's always a scenario where an option strategy loses. In a merger arb it could be the deal falling apart or another suitor coming along or a negative reaction to the acquirer, etc.
  8. short pfizer bonds long wyeth stock.

    Pfizer's 5-year bonds now trade about 340 basis points over Treasurys. If its ratings get downgraded, yields on new debt could top 6.5%, pushing the spread even higher, Jaques said.
    At that level "people will definitely buy it," Jaques said.
    Pfizer anticipates its ratings will get downgraded by the ratings agencies, and it said it halved its quarterly dividend to 16 cents a share to prevent further erosion.
    Moody's Investors Service said it was putting Pfizer's Aa1 long-term ratings on review for possible downgrade and anticipated it could fall to A1, still well within the range of investment-grade credit. Standard & Poor's said it expected to lower Pfizer's ratings to AA from the coveted AAA rating.
    Carol Levenson, director of research at Gimme Credit, said it's not surprising that a high-quality company has been able to line up so much bank financing. But bond investors may not show the same comfort level as the banks did.

  9. Tide31


    Nravo, you asked two separate questions:

    To answer the 2nd Q: it doesn't do anything for you to do a buy/write on WYE and Short/write on PFE. Taking in a minimal amt of premium on WYE is all you do on the one side, and similarly hedged on PFE.

    To answer the 1st Q: Options on event driven situations are not priced in the traditional manner necessarily (off volatility). Arbs and options market makers price them off the expected close and expected downsides if there is no close. The deal return is about 12% gross/24% annualized using 6Mos. Without going that far into detail, the right way to 'hedge' the event risk would be long WYE and long puts and short PFE and long calls. The deal is 70% cash, and the stock portion is approx. 1 to 1. The risk/reward is about 2 to 1. You can make $5 if it goes thru or lose $10 if it doesn't. WYE goes back down about $7 and PFE goes back up $3. By the time you are done with your hedging strategy you will pay about $3-$4 to hedge against a broken deal. So say $1.50 in net profit over 6 mos. is 3.5% gross or 7% annualized. For most arbs, they look at cost of funds of about 5%, and the options cannot be margined, so a 2% annualized net return would make this bet not worthwhile, and is why very few do it this way, and why options end up being priced this way (off supply/demand) in an event driven situation.

    Hope this helped!
  10. nravo


    It does and it conforms my suspicions; you got to a take the risk if you want the spread. Thanks.

    For financing, though I wonder if long WYE Deep ITM calls make more sense than long stock ... and, possibly, conversely long deep ITM Pfizer puts?
    #10     Feb 3, 2009