Let's look at one of the most common special situation strategies in equity markets, merger arbitrage, sometimes also called risk arbitrage.

The word risk refers to the possibility that a proposed takeover or merger may fail, perhaps because regulators block it, shareholders vote against it, or financing falls through.

In a typical merger or acquisition, a large company, let's call it Big Ink, or incorporated, announces that it'll buy a smaller company small ink at a premium to the current market price.

For example, if Smalls shares are trading at $120, big might offer $145 per share to persuade shareholders to sell.

At this point, a specific group of investors known as ARBs, short for Arbitrages Step in these are specialized hedge funds that focus on corporate events such as mergers, spinoffs, or restructurings.

Their goal is not to take a long term view on the companies themselves, but to profit from short term pricing inefficiencies that arise between the announcement of a deal and its completion.

In a merger situation, arbitrages look at the difference between the targets current market price and the value of what shareholders will receive if the deal closes that package.

The cash shares or mix of both offered by the acquirer is called the deal consideration.

The difference between the two, today's market price and the value of the deal consideration is known as the deal spread, and it represents both the potential profits and the risk premium, the uncertainty that the deal might not go through when a deal is announced, prices typically move in opposite directions.

The target companies shares in this case, smalls jump sharply toward the offer price, since investors expect to receive that value if the deal succeeds.

Meanwhile, the acquirer's shares bigs often fall slightly reflecting the cost of the acquisition and the risks of integrating another business.

But smalls share price doesn't usually rise all the way to the offer price.

It's trades at a discount to the offer price.

The deal spread, which reflects the market's view of how likely the deal is to complete the small and the discounts, the higher the perceived probability of success.

If investors think regulators or shareholders might block the deal, the discount widens occasionally the targets price, even trades above the announced offer, suggesting that investors expect a competing bid or a higher offer to emerge.

An arbitrage will typically buy the target company shares after the deal is announced, aiming to sell them at the offer price once the transaction closes.

The expected profit is the difference between today's price and the deal price adjusted for the time until completion.

This expected return is then compared to the risk-free rate and other market opportunities to judge whether the reward justifies the deal risk.

If the spread is wide, meaning the market is pricing in significant uncertainty, the potential return is higher, but so is the chance that the deal could collapse.

In some cases. If an investor believes the deal is unlikely to complete, they might take the opposite position.

For example, shorting the target or buying the acquirer's shares, which might rebound if the deal fails.