Pricing and Hedging Financial Derivatives in Merger\&Acquisition Deals with Price Impact

TL;DR

This paper analyzes optimal execution strategies and fee structures for various merger and acquisition contracts, considering market impact and manipulation risks.

Contribution

It derives optimal strategies and fees for linear, nonlinear, and Asian contracts under market impact, highlighting their vulnerabilities.

Findings

Linear cash-settled contracts are more expensive and susceptible to manipulation.

Nonlinear and Asian contracts also face manipulation risks.

Optimal strategies depend on contract type and market impact considerations.

Abstract

We investigate the optimal execution of contracts that are used in merger\&acquisition deals. We consider cash-settled and physically delivered contracts between a broker and a counterpart. Contracts are linear (total returns swaps), nonlinear (collar contracts) or Asian type (TWAP based contracts). We derive the optimal execution strategy and the optimal fee through indifference utility arguments allowing for linear market effects of trades. We show that linear cash-settled contracts are more expensive and more exposed to manipulation/statistical arbitrages by the broker. Also nonlinear and Asian type contracts are exposed to these phenomena.