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Lorillard (LO) / Reynolds acquisition news was announced today. Reynolds will buy LO for 68.88 per share. However, the stock dropped today to ~ $60.17. The out of the money call options also reflect the same story.

Even though the deal will not be closed until middle of next year, the LO stock will be purchased at the said price. Thats ~ 14.5% return in a year. Isn't this too good to be true?

Why is the market behaving this way? Is it that M&A firms are just closing the transactions which is putting downward pressure on the stock?

http://online.wsj.com/articles/reynolds-american-to-buy-lorillard-for-27-4-billion-1405422823

Thoughts? Thanks

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From my recollection of Warren Buffett's book "Warren Buffett and the Art of Arbitrage", the following factors determine the difference between the market price of a stock and the future expected price of an acquisition or merger:

  1. Time: Assuming the deal will close, the market price should approach the offer price as the closing date approaches. The fact that there is a 14% spread partially reflects the time value of money.

  2. Probability: Things could happen between now and closing date which could derail the deal. The higher the spread the more likely the market thinks the deal will not occur. For example, LO shareholders could reject the offer saying it is too low, or anti-trust regulators could say the deal is anti-competitive. Part of this 14% spread indicates the probability of the deal completing.

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    #2 is the largest source of the disparity. There are hedge funds that specialize in "Merger Arb" that employ teams of lawyers to review potential mergers and assess the likelihood of the merger going through or not – Thomas Johnson Jul 21 '14 at 18:14

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