Option Pricing on Cash Mergers

Ioanid Rosu, Victor Martinez and Alan Bester
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Ioanid Rosu: university of chicago - booth school of business - University of Chicago
Victor Martinez: Zicklin School of Business - Baruch College [CUNY] - CUNY - City University of New York [New York]
Alan Bester: university of chicago - booth school of business - University of Chicago

Working Papers from HAL

Abstract: When a cash merger is announced but not completed, there are two main sources of uncertainty related to the target company: the probability of success and the price conditional on the deal failing. We propose an arbitrage-free option pricing formula that focuses on these sources of uncertainty. We test our formula in a study of all cash mergers between 1996 and 2008 which have sufficiently liquid options traded on the target company. The estimated success probability is a good predictor of the deal outcome. Our option formula for cash mergers does significantly better than the Black– Scholes formula and produces a volatility smile close to the one observed in practice. In particular, we provide an explanation for the kink in the volatility smile and show that the kink increases with the probability of deal success.

Keywords: Mergers and acquisitions; Black–Scholes formula; success probability; fallback price; Markov Chain Monte Carlo.; Markov Chain Monte Carlo (search for similar items in EconPapers)
Date: 2009-09
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Published in 2009

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Persistent link: https://EconPapers.repec.org/RePEc:hal:wpaper:hal-00515906

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