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What do people mean when they talk about 'merger arbitrage'? Best Regards, Z.H.

Gregg Greenberg

: Very simply put, merger arbitrage is Wall Street's version of the popular television game show "Deal or No Deal," minus the studio audience and the beautiful women.

When one company acquires another, either for cash or its own stock, it shells out a premium above the target company's current stock price. That makes sense, right? If you are going to buy a company, you will most likely be forced to offer a high enough price for the company's management and shareholders to say "deal."

However, just because the combination sounds good doesn't guarantee that it will be consummated. Many things could go wrong, such as new bidders entering the fray, unforeseen product lawsuits and, most importantly, regulatory problems. The merger needs the blessing of the government, which can step in and say "no deal" if it deems the plan anticompetitive.

Because of these potential deal breakers, a "spread" is created between the target's current price and its acquisition price. It's the arbitrager's job to safely capture that spread by purchasing the stock of the target company and, in some cases, shorting the stock of the acquirer.

The fact that a deal may collapse heightens the need for intelligent analysis. In cash deals, for example, merger arbitragers often just buy the target, so any last-minute breakdowns can cause a major drop in the shares of the company being acquired.

Merger arbitragers have been busy with all the deal-making going on in the market recently. And its not just simple cash deals.

Last week, for instance, Charlotte, N.C.-based


(WB) - Get Report

announced a $25 billion agreement to buy

Golden West Financial


, the nation's second-largest savings and loan. The cash and stock deal, if completed, will give Wachovia a strong foothold on the West Coast and make it a major player in the home-lending market.

Terms of the agreement call for each Golden West share to be exchanged for a package of 1.051 shares of Wachovia common stock and $18.65 in cash. Based on Wachovia's closing stock price on the Friday before the deal was announced, this equals $81.07, a 15% premium over Golden West's closing price of $70.51.

Initially, investors and many analysts gave the deal a thumbs-down, at least with regard to Wachovia shares. In early trading after the deal was announced, the stock dropped $3.50, or nearly 6%, to $55.89. Shares of Golden West, not surprisingly, were up sharply, rising $5.51, or 8%, to $76.02.

If that's the case, then arbitragers betting that this deal goes through are looking to capture a spread of $1.37, or the difference between Wachovia's offer of $77.39 a share ($55.89 multiplied by 1.051 plus $18.65) and Golden West's price of $76.02.

Wachovia said it expects to close the deal in the fourth quarter of this year. Of course, a lot can happen between now and then, which means arbitragers will be wondering if it's worth playing this game -- and tying up all those dollars -- for a 1.8% return.

In other words, time is also an important factor in judging whether an arbitrage deal is worth investing in. For example, if the acquisition closes in a month -- way ahead of schedule -- then the annualized return is 15.6%, or 1.8% multiplied by 12 months. Given the risk of this deal and interest rates, that's not a bad return.

But if regulators hold up the deal or it hits a snag and the closing is delayed, then arbitragers may decide that the risk isn't worth the return. They may do better in a far less risky municipal bond than waiting around for this corporate couple to finally seal the deal.