arbitrage is not necessarily insensitive to the performance of the stock market in all market conditions. When the stock market experiences a decrease of 4% or more, the beta (finance) between merger arbitrage returns and risk arbitrage returns can increase to 0.5. This suggests that the exposure to market risk is asymmetric: the arbitrageur does not participate in market rallies, but tends to suffer losses in downturns. Returns In the long run, risk arbitrage appears to generate positive returns. Baker and Savasoglu replicated a diversified risk arbitrage portfolio containing 1,901 mergers between 1981 and 1996; the portfolio generated excess annualized returns of 9.6%. Maheswaran and Yeoh examined the risk-adjusted profitability of merger arbitrage in Australia using a sample of 193 bids from January 1991 to April 2000; the portfolio returned 0.84% to 1.20% per month. Mitchell and Pulvino used a sample of 4,750 offers between 1963 and 1998 to characterize the risk and return in risk arbitrage; the portfolio generated annualized returns of 6.2%. The arbitrageur can face significant losses when a deal does not go through. Individual deal spreads can widen to more than fifty percent in broken deals. The HFRI Merger Arbitrage Index posted a maximum one-month loss of -6.5% but a maximum one-month gain of only 2.9% from 1990 to 2005. Merger arbitrage is significantly constrained by transaction costs. Arbitrageurs could generate abnormally high returns using this strategy, but the frequency and high cost of trades negate much of the profits. Example Suppose Company A is trading at $40 a share. Then Company X announces a plan to buy Company A, in which case holders of Company A's stock get $80 in cash. Then Company A's stock jumps to $70. It does not go to $80 since there is some chance the deal will not go through. In this case, the arbitrageur can purchase shares of Company A's stock for $70. He will gain $10 if the deal is completed and lose $30 if the deal is terminated (assuming the stock returns to its original $40 in a break, which may not occur). According to the market, the probability that the deal is consummated at its original terms is 75% and the probability that the deal will be terminated is 25%. The arbitrageur has three choices: Purchase Company A's stock at $70. They would do this if he believes the probability that the deal will close is