1. Using Option Prices to Infer Overpayments and Synergies in M&A Transactions Kate Barraclough, Vanderbilt University David Robertson, Duke University Tom Smith, UQ Business School Robert E. Whaley, Vanderbilt University

2. Overview Stock price reactions to M&A announcements reflect market beliefs about: – Stand alone values of the firms involved – Potential synergies – Bidder overpayment We show how call options written on the firms involved can be used to augment stock prices in uncovering market beliefs.

3. Event Study Approach Traditional method for determining takeover value. – Calculate abnormal returns to bidder – Calculate abnormal returns to target – Possibly use dollar values – Add these together to get gains from takeover Bradley, Desai and Kim (1988).

4. 0 0 Target Cumulative Abnormal Return Bidder Cumulative Abnormal Return Event Study Approach

5. Problems with Event Study Approach Market does not assess probability of takeover at 1 Gains from successful takeover computed from stock price changes on announcement will be understated.

6. Problems with Event Study Approach Takeover bid will result in new information being released about the target and the bidder News about the bidder and news about the target needs to be treated separately to gains to target and gains to bidder. Look at an example re the bidder

7. 0 Bidder Example Abnormal Return

8. 0 Bidder Example Abnormal Return

9. 0 Bidder Example News About Bidder

10. 0 Bidder Example News About Bidder Gain to Bidder

11. Related Literature Problems widely recognised in M&A literature but few attempts to circumvent. Closest papers are Hietala, Kaplan and Robinson (2003) and Bhagat, Dong, Hirshleifer and Noah (2005). – Hietala et al use a case study of Viacom and Paramont merger. – Bhagat et al use probability scaling and intervention methods.

12. Related Literature Probability scaling method rescales annoucement date returns by an ex post measure of probability of success. Intervention method uses returns at dates of intervening events eg a competing bid, shareholder litigation or regulatory opposition.

13. Related Literature Probability scaling method: – Compute an estimate of market’s perception of probability of success. – Based on a logit of past outcomes and various ex- post explanatory variables. – Condition on litigation, target management opposition, competing bids, premium and toehold. – Probability not specific to a particular offer.

14. Related Literature Intervention method requires ex post data on: – Probability of success of initial bidder – Probability of success of initial bidder given the arrival of a competing bid – Expected price paid by initial bidder given a successful bid – Expected price paid by initial bidder if successful given the arrival of a competing bid

15. Related Literature Ex post estimation based on actual outcomes across all takeovers. Estimated probability of success is not specific to each merger. Not possible to disentangle sources of takeover value on announcement.

16. Contribution Our method provides ex ante estimation of parameters of the takeover. We show that the ex ante parameters provide a much better fit with actual outcomes than the ex post parameters used in previous literature. Can determine specific values for components of takeover value.

17. Contribution We are able to estimate the ex ante parameters right from the time of initial announcement of takeover. Do not have to wait for intervening event. We can update ex ante parameters daily or in real time. Do not have to wait for intervening events. Important as prices can change due to informed trading and do not need public announcements to update.

18. Model Bidder price is a probability weighted average of price if successful and price if unsuccessful Target price is a probability weighted average of price if successful and price if unsuccessful

19. Model Total value changes accruing to successful bidder and target are The total value change can be written as the sum of 4 components:

20. Model The total value change can be written as the sum of 4 components: Gains to bidding firmNews about bidding firmGains to target firmNews about target firm

21. Model The total value change can be written as the sum of 4 components: Total synergy gains are

22. Model Using stock prices alone the problem is under- identified: 4 unknowns,, and But only two stock prices and Use call option prices to augment stock price information.

23. Option Prices Call options on the bidding firm: Observed call price Call price if successfulCall price if unsuccessful

24. Option Prices Call options on the target: – Cash offers: – Stock offers: Fixed cash offer priceStock offer ratio

25. Parameters Price of the bidder if it succeeds: Price of the bidder if it fails: Price of the target if unsuccessful: Probability of success: Volatility of the bidder if successful: Volatility of the bidder if unsuccessful: Volatility of the target if unsuccessful:

26. Parameters Use stock prices and call option prices of bidder and target to uncover parameter values Need at least three calls on bidding firm and two calls on target firm. Ensure call prices contain information relevant to the announcement. Exclude options expiring before effective/withdrawal date. Exclude options with zero trading volume or zero bid price.

27. Parameters To solve for parameter values we need an option valuation model. Stock options traded in the U.S. are American- style and firms may pay dividends. We use a dividend-adjusted binomial method and Cox, Ross and Rubinstein (1979) parameters. Exclude day before ex-dividend to avoid problem of early exercise.

28. Parameters Starting values are: – Pre-bid average prices over (-T,-1) period. – Pre-bid return volatility over (-T,-1) period. – Pre-bid return correlation over (-T,-1) period – Use T of 60, 30, 5 days – Probability of success based on target stock price response

29. Data US Domestic tender offers January 1996 through December 2008. SDC and Factiva for announcement details. CRSP for share price and dividend information. Datastream for Eurodollar spot rates. Compustat and Risk Metrics for firm characteristics. Option Metrics for option data.

30. Results

31. Market Activity of Options

32. Results Returns

33. Results Dollar Values

34. Sample Selection Focus on Takeovers where both Bidder and Target have listed options Heckman Sample Selection Correction Shows that the Target Gain is understated

35. Overall Results Takeovers do add value – the Bidder gains and the Target gains Split up of Gains using Returns: – 90% to Target; 10% to Bidder Split up of Gains using Dollar Values: – Closer to 50% Target; 50% Bidder Traditional Methods understate true synergy gains of takeovers. Helps us to understand why takeovers continue to be an everyday business strategy.

36. Conclusions We show how call options written on the firms involved in M&A activities can be used to augment stock prices in uncovering market beliefs. Our method provides ex ante estimation of parameters of the takeover. We show that the ex ante parameters provide a much better fit with actual outcomes than the ex post parameters used in previous literature.

37. Conclusions We are able to estimate the ex ante parameters right from the time of initial announcement of takeover. Do not have to wait for intervening event. We can update ex ante parameters daily or in real time. Do not have to wait for intervening events. Important as prices can change due to informed trading and do not need public announcements to update. Able to extend the model to multiple bidders Show that M&As are not value destroying as the recent literature would have you believe.