Stellan Pharma offers 0.5 of its shares for each Moravi Labs share. Stellan trades at Rs 800 and Moravi at Rs 370, and Moravi would fall to Rs 280 if the deal broke. What is the spread, how do you hedge it, and what completion chance is the market pricing?

The spread is Rs 30 a share, 8.1% over about six months, against Rs 90 of downside if the deal breaks, which prices roughly a 75% chance of completion. Buy Moravi and short 0.5 Stellan for each Moravi share, so the Rs 30 is locked in whatever Stellan does. The trade makes sense only if you think completion is clearly more likely than 75%, and it is sized by the loss on a break, not by the spread.

Moravi's shareholders will receive 0.5 Stellan shares, worth 0.5 x 800 = Rs 400 today, yet Moravi trades at Rs 370. The Rs 30 gap, 8.1% of the price, is what the market pays you to carry the risk that the deal breaks. Think of buying a concert ticket for Rs 370 that will be worth Rs 400 on the night, from someone worried the concert might be cancelled, in which case the ticket is worth Rs 280 as a souvenir. The seller is not being careless; the discount is the price of the cancellation risk. Compounded over two half-years, 8.1% is 16.9% a year, the number deal spreads are usually quoted in.

Buy one Moravi share and short 0.5 Stellan shares. If the deal closes, your Moravi share turns into 0.5 Stellan shares, which you deliver against the short. The hedge ratio equals the exchange ratio, so on completion the two legs cancel and you keep exactly the Rs 30 spread whatever Stellan's price does in between. If Stellan falls to Rs 700, Moravi converts into Rs 350 of stock, a Rs 20 loss on the long, but the short, sold for Rs 400, is bought back for Rs 350, a Rs 50 gain: net Rs 30 again. This is the merger arbitrageBuying the target of an announced deal and, in a stock deal, shorting the acquirer, to earn the gap between the market price and the deal value if the deal completes. position in its standard form.

This ignores the time value of money and the cost of borrowing Stellan shares, both small over six months, so the true implied figure is a shade higher. The payoff is lopsided: you make Rs 30 three times in four and lose Rs 90 one time in four, so the trade behaves like selling insurance. That shape is why merger arbitrage returns look steady for long stretches and then fall sharply when several deals break together in a market sell-off.

Start from your own probability, not the market's. If your work on the competition review says completion is 90% likely, the expected gain is 0.9 x 30 minus 0.1 x 90, which is Rs 18 a share, 4.9% over six months. Size by what a break would cost, because that is the number that hurts: a break costs 90 / 370 = 24.3% of the Moravi position. If the fund allows a single deal to lose at most 1% of NAV, the position can be about 4.1% of NAV. The table shows why to keep a margin below that: acquirers often rally when a deal dies, and the short leg then adds to the loss.