V. Martinez, I.Rosu and C. Bester: Option Pricing on Cash Mergers

September 30, 2009

When a cash merger is announced but not completed, there are two main sources of uncertainty related to the target company: the probability of success and the price conditional on the deal failing. We propose an arbitrage-free option pricing formula that focuses on these sources of uncertainty. We test our formula in a study of all cash mergers between 1996 and 2008 which have sufficiently liquid options traded on the target company.