The shares of an Italian firm have been trading earlier around €6. Recently, a Spanish firm entered into talks with the Italian firm to acquire it. The Spanish firm offered two of its shares for every three shares of the Italian firm. The boards of directors of both firms have approved the merger, and ratification by shareholders is expected soon. The shares of the Spanish firm are currently trading at €12.50, and the shares of the Italian firm are trading at €8.
a. Should the shares of the Italian firm trade at a discount? Explain.
b. What position do you think a hedge fund that specializes in risk arbitrage in mergers and acquisitions will take in the two firms? Assume that the hedge fund's position will involve 250,000 shares of the Italian firm.
c. It turns out that the European Union commission does not approve the merger because it fears that the merged firm will have a monopolistic position in its industry. After this announcement, the shares of the Italian firm fell to €6.10 each. The shares of the Spanish firm are still trading at €12.50 each. Discuss the consequences for the hedge fund. Ignore the cost of securities lending and margins deposit.