HEC Research Papers Series,
HEC Paris

Abstract: In an empirical study of cash mergers since 1996, we find that the equity options on target firms display a pronounced smile pattern in their implied volatilities which gets more pronounced when the merger success probability gets higher. We propose an arbitrage-free model to analyze option prices for firms undergoing a cash merger attempt. Our formula matches well the observed merger volatility smile. Furthermore, as predicted by the model, we show empirically that the merger volatility smile has a kink at the offer price, and that the magnitude of the kink is proportional to the merger success probability.

Keywords: Mergers and acquisitions; Black-Scholes formula; success probability; fallback price; Markov Chain Monte Carlo

JEL-codes: G13; G34

51 pages, First version: November 21, 2017. Revised: July 12, 2018. Earlier revisions: November 21, 2017.

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