Of the Lovely Art of Arbitrage

Yahoo (YHOO) shares shot up 48 percent to $28.33 Friday morning on news of the $45 billion Microsoft Corp (MSFT) offer to buy the company. Microsoft’s bold move, many speculate, could create a combined entity better able to respond to the growing dominance of Google Inc. (GOOG) in web search and digital advertising.

Microsoft’s $45 billion dollar deal comes out to roughly $31 dollars per Yahoo share or just shy of one share of Microsoft. If Microsoft offered $31 dollars per share, why is Yahoo trading at just over $28? Shouldn’t Yahoo be trading closer to if not at the $31 dollar mark?

The difference between a stock’s price and the deal value is called the spread, similar to the odds placed on sporting events. Spreads exist for two primary reasons: (1) the time value of money, and (2) a risk premium in case the deal never happens. And if last night’s super bowl is any indication, spreads are often horrible predictors of the future. Some quick math will tell you that the Microsoft/Yahoo deal has a very thin margin of less than 10%. Not worth the risk in my opinion, especially, if you take into account the fact that the offer hasn’t been agreed upon and there is no telling how long the deal will take.

The investment in securities affected by corporate reorganizations is called risk arbitrage. This trading strategy is commonly associated with hedge-funds and is reserved only for those with a natural affinity for research coupled with the risk aversion of a professional no-limits poker player.

What speculators seem to be counting on is a situation that could really raise the stakes. As I understand it, Microsoft has been trying unsuccessfully to buy Yahoo behind the scenes for over a year but the Yahoo board wouldn’t budge. Now that Yahoo’s stock has tumbled, Microsoft has upped the ante by making the offer public, hoping that shareholders will put pressure on Yahoo’s board to sell out. If the board still doesn’t sell, Microsoft can take a new offer directly to the shareholders in what’s called a hostile takeover.

A more plausible outcome, however, is one in which Yahoo puts the company up for auction. Analysts have pegged Comcast Corp (CMCSA), Viacom Inc (VIA-B) and General Electric Co (GE) as possible bidders. I can’t imagine the cash rich Microsoft folding in a pricing war but the presence of other bidders could be just enough to make Microsoft over pay for an otherwise struggling Yahoo. But, don’t forget, Google still has the anti-compete card up its sleeve.