Essays on Using Options to Elicit Market Beliefs about Mergers

Abstract

The first essay of my dissertation introduces a new method for eliciting market beliefs about the expected outcomes of a merger negotiation after announcement. During a merger negotiation, the market prices of the firms involvedreflect beliefs about their values both in the merged andstandalone states, as well as the likelihood of either outcome.These beliefs determine stock price reactions to news of a possiblemerger, but those prices alone do not contain sufficient informationto identify the latent beliefs that they reflect. I develop a newmethod which, by using additional data in the form of option prices,is able to identify these beliefs. This method allows for a cleardecomposition of a negotiating firm's expected value change into twoparts: the value of the transaction to the firm, and new informationabout its standalone value. Previous research into estimatingmerger synergies has struggled to obtain an appropriate alternativeagainst which to measure the realized outcome. The market's beliefsabout state-contingent firm values give an estimate of both. Througha direct comparison of the estimates of a firm's value in both themerged and standalone states, I obtain a strong, practical measureof the expected value-creating potential of a merger before itsconsummation.The second essay applies the state-contingent payoff estimation method developed previously to addressing questions about the size effect in mergers. A growing body of evidence indicates that large acquisitions destroy value. However, we do not yet know why. Several theories have been advanced, but their effects are difficult to observe in isolation. It has thus been impossible to tell whether negative post-announcement acquirer returns are caused by market expectations of value-destroying acquisitions or revealed bad news about standalone value. This paper resolves this issue by decomposing expectations about merger outcomes into expected value change from completing the acquisition and revision of beliefs about standalone firm value. The data show that deal size is correlated with value destruction, while acquirer size is correlated with release of unfavorable information. Deal size correlates with value destruction, acquirer size with bad news about the firm. Furthermore, the results suggest that overpayment is a prerequisite for large acquisitions. These findings reduce the set of possible theoretical explanations for the size effect.