Something for Nothing
In the world of investments there are few things we know for certain. Nonetheless, we buy assets in the hope that the prices will go higher from where we got in. We try to justify our conviction by some fundamental or macroeconomic rationale, but in the end we trust that things have historically gone up, so it doesn’t really matter that we have no clue about the future anyway.
Well what if we did? If we knew for sure that something is going to happen at an exact time and specific date, that would give us a massive advantage in how we allocate our capital. Which is why so called “event-driven” strategies have been so successful over many decades now. Basically, it works like this: Say Mike Ashley has finally had enough of buying up the high street and decides to buy Tesla for 400 USD per share. Currently, that stock is trading at 275 and the minute this offer is announced, the price would immediately go higher. It usually takes about 6 months for any such transactions to close and that’s because the regulators and shareholders have to approve the deal. Which is why the share price tends to trade at a discount to the offer price, reflecting the risk that the proposed deal is withdrawn or rejected.
The nice thing is, the market does all the work for us and the very percentage of the discount will perfectly reflect the probability of the deal going through. If people thought that Elon and Mike will never get on, then the stock price of Tesla may not move at all, on any such take over offer. Not surprisingly the markets are very efficient at putting a price on risk, but that also makes using event-driven strategies so attractive. By simply allocating to many of those trades with high implied probabilities of going through, we can skew the numbers in our favour.
There are many other things we know for certain, that will happen in the future: elections, corporate actions, index changes, or that the UK will leave the EU on March 29th (just kidding). The point is, when we can speculate on specific and known situations, we don’t have to care what happens anywhere else in the world or the general markets. This has two advantages: one, it diversifies whatever else we are doing. Two, we can control the risk we want to take on very precisely. Knowing exactly what is going to happen at a specified point in time, is certainly better than nothing in a world that is random. In the land of the blind, the one-eyed giant is king indeed.