What is the difference between pure arbitrage and risk arbitrage?

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What is the difference between pure arbitrage and risk arbitrage?

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What is the difference between pure arbitrage and risk arbitrage?

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Explanation

Bonds are given low ratings by the ratings companies when their issuers show financial weakness or increased risk of default. As a result, their prices would drop and their coupons would thus offer higher yields to compensate investors for the increased risk. Troubled companies did not usually try to acquire other firms by issuing more low-rated bonds on top of what they already had outstanding. Healthy companies who raised money for acquisitions would attract investors for their bonds through their high ratings. In other words, bonds generally only received low ratings if their issuers weakened financially after the bonds were issued.
That changed in the 1980s when firms like Drexel Burnham Lambert convinced financially healthy companies to issue new bonds for acquisitions that were intentionally set with high coupons to attract investors. The high coupons cost issuers more for financing, but they were generally used to make larger (and therefore more risky) acquisitions and were planned to be retired once those acquisitions could be completed and the financial benefits of the merger realized. In such instances, the target companies were even larger than the acquiring companies. The issuance of these low-rated (junk) bonds was accompanied by more comprehensive financial analysis on the target company as well. As more companies used this procedure to finance large acquisitions, they became more acceptable to investors and fueled a wave of such acquisitions.

Verified Answer

High-yield bonds essentially provided a new way to finance mergers, thereby contributing to the wave of mergers in the US during the 1980s.

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