Daniel Schwartz FALL 2009

daniel.schwartz@aqr.com

Arbitrage: A Brief Introduction

Arbitrage strategies use relative value trades to generate

excess returns with attractive risk profiles. Their low betas
with respect to traditional asset classes make arbitrage
strategies particularly effective components of a diversified
portfolio. This paper offers a brief introduction to arbitrage,
including descriptions of several common strategies and
an overview of their historical performance.

The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be
reliable. However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness,
nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided
to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to
purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use
of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. This document is
subject to further review and revision. PLEASE SEE IMPORTANT INFORMATION AND RISK DISCLOSURES ON THE LAST PAGE.
WHAT IS ARBITRAGE?
Arbitrage strategies are often defined as riskless profit
opportunities. They consist of the simultaneous
purchase and sale of two assets that are substantially
similar or related, but that have different prices. By
being long the “cheap asset” and short the “expensive
asset,” an arbitrageur seeks to profit from an eventual
price convergence. Since the real world presents very
few truly riskless opportunities, arbitrage strategies
are more accurately defined as relative value trades
that offer attractive risk-adjusted returns.
For investors, especially in light of the events of
2008, arbitrage has another desirable characteristic:
low beta with respect to traditional asset classes.
While all types of arbitrage have some risk, in most
cases this risk is largely independent of equity and
debt markets. For this reason, arbitrage strategies are
often referred to as “market-neutral”. Over the long
term, these market-neutral strategies can improve a
portfolio’s risk/return profile by reducing portfolio
volatility through market cycles.
COMMON TYPES OF ARBITRAGE
In theory, arbitrage opportunities are possible for
virtually every kind of asset, wherever price discrep-
ancies occur. In practice, transaction costs and other
frictions limit the investable universe of arbitrage
strategies. This paper focuses on several common
arbitrage strategies, namely: merger arbitrage, convert-
ible bond arbitrage, and other event-driven arbitrage
strategies.
Merger Arbitrage
When a merger is announced, the target company’s
stock price generally increases, but not fully to the
price offered by the acquirer. The remaining spread
reflects the risk that the merger will not be completed.
Arbitrageurs can earn this positive spread for deals
that are successful if they are willing to assume the
2 | F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N LY
risk that the deal fails – an event that typically results
in a large loss. Seen another way, arbitrageurs capture
a risk premium in exchange for providing liquidity to
those investors who no longer have a desire to hold
shares in a target company and bear the risk of deal
failure.
Most mergers fall into two general categories defined
by the form of payment: cash mergers and stock
mergers. InBev NV’s 2008 acquisition of Anheuser-
Busch is an example of a cash merger. The day after
InBev announced its intention to purchase Anheuser-
Busch for $70 per share, Anheuser-Busch’s stock
price rose to $66.60. The typical merger arbitrage
trade would be to buy Anheuser-Busch for $66.60
and to sell Anheuser-Busch stock to InBev for $70.00
upon consummation of the merger. In addition, the
arbitrageur would collect dividends on Anheuser-
Busch stock paid prior to the merger closing
date. Including $0.74/share in dividends, the spread
between the offer price and the market price was
6.2%. Amortizing this spread over the 126 days until
deal completion provided a potential annualized
return of 19.1%.
Because the offer price in a cash merger is fixed,
capturing the arbitrage spread can be accomplished
simply by purchasing the target stock. However, in a
stock merger, capturing the arbitrage spread requires
the purchase of the target’s stock and the simultane-
ous short selling of the acquirer’s stock. The 2008
acquisition of Merrill Lynch (MER) by Bank of
America (BAC) is a recent example of a stock merger.
BAC offered 0.86 shares of its stock for each share of
MER, an offer that amounted to $25.40 per share.
After the announcement, MER jumped to $22.18,
leaving a deal spread of 14.5% over the following
107 days to expected completion, providing an
attractive potential annualized return of 58.7%. The
typical arbitrage trade would be to buy MER stock
and to sell short 0.86 BAC shares for each MER share
purchased. Arbitrageurs who implemented this trade
isolated the spread between the two stock prices, and
created a market-neutral investment whose primary
Please read important disclosures at the end
 Exhibit 1: HFRI Merger Arbitrage Monthly Returns January 1990 – July 2009

HFRI Merger Arbitrage Monthly Returns

January 1990 – July 2009

4%

2%
Monthly Return

0%

-2%

-4%

-6%

-8%
Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09
Source: Hedge Fund Research, Inc. © 2009, www.hedgefundresearch.com

risk was that of deal failure. In this way, merger typically modest and downturns rarely last longer
arbitrage is analogous to writing insurance against than 1-3 months (see Exhibit 1) .
deal failure. A merger arbitrageur collects a positive
spread on the many merger deals that are completed, Convertible Bond Arbitrage
but faces the potential for loss when a merger fails.
A convertible bond is a corporate bond that can, at
By investing in a sufficiently large number of merger the option of the holder, be converted into common
deals, and by employing appropriate risk controls, stock. Because of the conversion feature, a convert-
the arbitrageur is able to build a portfolio that seeks ible bond is a hybrid security that bundles together a
to generate attractive returns with little systematic corporate bond and an equity call option.
risk. However, as first demonstrated by Mitchell and
Pulvino (The Journal of Finance, 2001)i, in a falling Each convertible bond has a conversion ratio which
stock market, merger arbitrage has a historical beta is the number of shares into which the bond may be
of approximately 0.3. As the market declines, cash converted. The conversion price is the stock price at
buyers often seek to re-negotiate the purchase price which the holder is indifferent between receiving par
or terminate the merger, and thus cash mergers have value and converting the bond into common stock.
a greater tendency to fail when markets decline. Therefore, the conversion price is effectively the
However, the impact on merger arbitrage strategies is strike price of the embedded stock option.

F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N LY Please read important disclosures at the end | 3

In theory, a convertible bond’s fundamental value is
simply the sum of the values of its two components,
each of which can be determined in a fairly straight-
forward manner. The strategy in convertible bond
arbitrage is to identify situations in which the
convertible bond is trading at a discount to its fun-
damental value. When this occurs, arbitrageurs buy
the convertible bond and synthetically sell the
embedded call option by short selling the company’s
common stock. By doing so, arbitrageurs capture the
spread (the difference between market value and
fundamental value) as the bond matures, is put to the
company, or is called by the company, bearing the
risk of a limited secondary market. By building a
diversified portfolio and by employing portfolio level
credit and interest rate hedges, convertible arbi-
trageurs seek to generate excess returns that have low
correlation with traditional asset classes.
An example of a convertible arbitrage trade involves
the $600 million convertible bond issue by Textron
in April 2009. Each $1,000 face value bond is
convertible into 76.1905 shares of Textron common
stock. The bonds began trading in the secondary
market at a price of $131.70. Based on the credit
spread from a Textron bond with similar maturity
and seniority, but without the embedded call option,
the bond portion of the Textron convertible was
worth $90.68. Furthermore, call options with the
strike price and expiration date similar to the option
embedded in the convertible bond were trading at
$0.69 providing value of $52.49 1. Thus, the sum of
the components were worth $143.17 2 and therefore
the convertible bond was trading at an approximately
8% discount to fundamental value. Convertible
arbitrageurs sought to profit from this discrepancy
by buying the convertible bond, short selling the
underlying common stock, and hedging the bond’s
contribution to portfolio credit and interest rate risk.
1
Conversion ratio 76.1905* Market price of option $0.69=$52.49
2
Value of straight bond $90.68+ Value of embedded option $52.49=$143.17
4 | F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N LY
Event-driven Arbitrage Strategies
Merger arbitrage and convertible bond arbitrage are
probably the most well-known arbitrage strategies.
There are, however, a number of other miscellaneous
arbitrage strategies that are typically classified under
the broad name “event arbitrage”. A few common
types of event arbitrage strategies are described below.
Stub Trades
Arbitrage opportunities often arise when a publicly
traded firm has an ownership stake in a
publicly traded subsidiary. If the value of the parent’s
ownership stake in the subsidiary is large relative to
the value of the parent firm, the value of the parent’s
remaining assets can be undervalued. The arbitrage
strategy is to buy the parent stock and short the
subsidiary stock based on the number of subsidiary
shares held by the parent firm. By undertaking this
trade, the arbitrageur isolates the value of the “stub”
assets, which if undervalued should appreciate
through time.
A stub-trade arbitrage opportunity occurred in
November 2008 when Time Warner (TWX) decided
to split-off Time Warner Cable (TWC). As part of the
deal, TWX would exchange 0.2496 shares of TWC
for every share of TWX. TWC closed at $17.99 on
November 20, 2008 making 0.2496 shares of TWC
worth $4.49 3. TWX closed at $8.14 on the same date.
As a stub is the value of the parent’s assets less their
stake in the subsidiary, the implied stub price was
$3.65 4. This compares to an estimate of $6.50 5 for
the fair value of the stub and suggests that the stub
was trading at more than a 40% discount. Stated
differently, the market price of $8.14 for TWX, was
far less than the sum of the parts of TWX at $10.99 6,ii.
To capture this price discrepancy, an arbitrageur
would short 0.2496 shares of TWC for every share
of TWX with the expectation that the stub would
appreciate over time.
3
Market price of TWC $17.99 * Exchange ratio of spin-off 0.2496=$4.49
4
Market price of TWX $8.14- Value of TWC when exchanged $4.49=$3.65
5
Jefferies Equity Research, November 2008
6
Fair value of stub $6.50 + Market value of exchanged shares of
TWC $4.49= $10.99
Please read important disclosures at the end
When-issued Arbitrage
When-issued arbitrage opportunities arise immedi-
ately prior to spin-offs and other corporate actions.
At that point, up to four securities are traded in the
market: Parent shares, Subsidiary shares, When-Issued
Parent shares and When-Issued Subsidiary shares.
A “when-issued” parent share is the stock that begins
to trade prior to a spin-off but reflects firm assets
after the spin-off (i.e. when-issued parent shares
reflect parent shares without the subsidiary assets).
A “when-issued” subsidiary share is simply a right to
receive a subsidiary share following the spin-off.
When-issued subsidiary and when-issued parent
shares often trade at premia or discounts to the regular
subsidiary and parent shares. Arbitrageurs capture price
discrepancies by buying and shorting shares
of the parent, the subsidiary, and the when-issued
shares.
A when issued arbitrage opportunity occurred with
Altria’s spin-off of Kraft in March 2007. Altria
distributed approximately 89% of Kraft’s outstanding
shares owned by Altria to Altria shareholders.
Specifically, for each outstanding share of Altria,
Altria distributed 0.7 shares of Kraft. On March 22,
Altria closed at $86.15 and Kraft closed at $31.85.
The theoretical value of the Altria “stub” (Altria ex-Kraft),
was $63.85 7. However, the when-issued stock of
Altria closed at $64.43. To capture this price discrep-
ancy, an arbitrageur would buy Altria and short both
Kraft and when-issued Altria (w/o-Kraft).
Dual-Class Arbitrage
Dual-class stocks are different classes of common
stock issued by the same company. Companies issue
different share classes for various reasons, but it
usually involves tax and control considerations.
Typically, each class of stock is entitled to the same
cash flow interest in the company, but one share class
has superior voting rights (e.g. 10 votes per share).
7
Market price of Altria $86.15 - .7 Market price of Kraft $31.85 = $63.85
F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N LY
As the stocks are traded, technical market forces can
cause prices of the different classes to diverge. When
this occurs, a dual-class arbitrage opportunity arises
and an arbitrageur can earn the spread between the
two classes. The typical dual class arbitrage trade is
to wait for the spread to become abnormally large
and then buy the “cheap” class of stock and short the
“expensive” one, taking on the risk that the anticipated
spread reversion takes a long time to occur.
This type of arbitrage opportunity arose with Royal
Dutch Shell in the second quarter of 2008. On April
11, Royal Dutch Shell Class-A stock closed at $66.83
while Royal Dutch Shell Class-B closed at $65.69.
Arbitrageurs could have bought Class-B and shorted
Class-A. When the stock prices did converge on
May 2, the positions would have been sold and the
spread realized.
SPACs (Special Purpose Acquisition Companies) are
publicly traded “shell” companies whose primary
asset is a trust account invested in low-risk securities
such as Treasury bills. SPAC managers are typically
given 18-24 months to find an operating company to
purchase using the assets of the trust account. Once
the SPAC managers have found a candidate company,
the acquisition is presented to shareholders for a
vote. If the vote fails, money from the trust account
is returned to shareholders on a pro-rata basis.
However, even if the vote succeeds, shareholders
who vote against the acquisition are allowed to
redeem their pro-rata share of the trust account.
Under normal market conditions, SPACs trade at
close to fundamental value – the value of the
Treasury bills in the trust account. However, during
market dislocations, SPAC prices can trade at dis-
counts, creating arbitrage opportunities. Under these
circumstances, arbitrageurs capture the discount by
voting against acquisitions and receiving their pro-rata
portion of the trust account, paid in cash. Assuming
the opportunities are properly identified, SPACs
represent a relatively low risk arbitrage strategy.
Please read important disclosures at the end | 5
 Exhibit 2: HFRI Index Returns January 1990 – July 2009

HFRI Merger HFRI Convertible HFRI Event S&P 500 Merrill Lynch
Arbitrage Index Arbitrage Index Arbitrage Index Index 3-Month T-Bill Index
Annualized Return 9.5% 8.5% 12.2% 5.4% 3.9%
Volatility 4.3% 6.6% 7.0% 15.1% 0.5%
Sharpe Ratio 1.24 0.69 1.14 0.1 0.0
Alpha (annual) 5.1% 4.2% 7.4% 0.0% 0.0%
Beta to S&P 500 0.15 0.19 0.32 1.00 0.00

Source: Hedge Fund Research, Inc. © 2009, www.hedgefundresearch.com

RISK AND RETURN CHARACTERISTICS ARBITRAGE AND THE DIVERSIFIED

OF ARBITRAGE STRATEGIES PORTFOLIO

Arbitrage strategies have a long history of attractive
risk-adjusted returns. Exhibit 2 shows the perform-
ance of the HFRI Merger Arbitrage, HFRI Convertible
Arbitrage, and HFRI Event-Driven Arbitrage Indices
compared to U.S. equity and U.S. Treasury Indices.
The alphas, or excess returns, of the arbitrage strategies
range from 2.5% to 7% with volatilities between 4%
and 7%, substantially lower than the U.S. equity
market. Low betas relative to the S&P 500 and attrac-
tive Sharpe ratios are key reasons investors look to
diversify their portfolios with arbitrage strategies.
To illustrate the diversification benefits of arbitrage
strategies, we compare two hypothetical portfolios:
a standard portfolio to a hypothetical enhanced
portfolio that includes arbitrage strategies from the
period January 1990 through July 2009. The standard
portfolio consists of 60% stocks, 30% bonds, and
10% cash 8. The modified portfolio features a 15%
arbitrage component, taken equally from stocks,
bonds, and cash and placed into the HFRI Merger
Arbitrage, Convertible Arbitrage, and Event-Drive
Arbitrage Indices. As shown in Exhibit 3 , the inclu-
sion of arbitrage strategies enhances returns while
decreasing volatility, resulting in a much improved
Sharpe ratio 9.

Exhibit 3: Adding Arbitrage to a Standard Portfolio – Hypothetical Example

Standarized Portfolio Enhanced Portfolio

(60% stocks, 30% bonds, 10% cash) (55% stocks, 25% bonds, 5% cash, 15% arbitrage)
Annualized Return 6.01% 6.70%
Volatility 9.32% 7.60%
Sharpe Ratio 0.26 0.39

Source: Hege Fund Research, Inc. © 2009, www.hedgefundresearch.com

8
Stock returns are taken from the S&P 500, bond returns are taken from the
Lehman Aggregate Bond Index and cash returns are taken from the Merrill
Lynch 3 Month T-Bill Index.
9
Hypothetical performance has many inherent limitations and is for
illustrative purposes only. No representation is being made that any fund
or account will or is likely to achieve profits or losses similar to those
shown herein.

6 | F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N LY Please read important disclosures at the end

CONCLUSION
Recent history has reminded investors of the
importance of diversification. Many individual
arbitrage strategies have low betas with respect to
traditional investment classes and, importantly, with
respect to each other. While not immune to global
economic crises, we have seen that arbitrage
strategies generally fall less than equity markets, and,
because of the convergence nature of the trades, tend
to recover losses following crises. For long-term
investors looking to enhance risk-adjusted returns
through market cycles, we think exposure to
arbitrage strategies is a practical option.

i
Mitchell, Mark and Todd Pulvino, Characteristics of Risk and Return
in Risk Arbitrage, Journal of Finance, December, 2001.
ii
Jefferies Equity Research Report, Special Opportunities, November 20, 2008.

DISCLOSURES:

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC its
affiliates, or its employees.

The information set forth herein has been obtained or derived from sources believed by author to be reliable. However, the author does not make any
representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does the author recommend that the attached
information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not
constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may
not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by the author, and it is not to
be reproduced or redistributed to any other person.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein.
No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are
frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program.
One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical
trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading.
For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely
affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading
program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading
results. Hypothetical performance results are presented for illustrative purposes only.

The arbitrage transactions described herein are strictly for educational purposes and are in no way a recommendation of specific securities or services.

There is no guarantee that these strategies will be successful.

F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N LY Please read important disclosures at the end | 7

AQR Capital Management, LLC | 2 Greenwich Plaza, Third Floor, Greenwich, CT 06830 | 203.742.3600 www.aqr.com