For such a simple concept, merger arbitrage is a pretty fancy term.

It works like this: one company announces a deal to acquire another. Shares of the acquired company rally on the news, rising to close to the agreed-upon price. There’s usually a small difference between the two values because there’s risk the deal doesn’t happen, but sometimes the company being acquired will trade at a premium to the price, usually when investors expect competing bids.

Investors then analyze the deal to see whether it will happen. They might talk to people in the know, or they might closely analyze the balance sheet of the acquiring company, or the company’s ability to borrow money. Deals that are paid for by cash are the best, since acquisitions financed by shares add another variable to the mix.

Let’s look at a real life example, Talisman Energy Inc (TSX:TLM)(NYSE:TLM). Back in December, after months of rumours swirling, Spanish energy producer Repsol finally offered to acquire the company for US$8 per share. Talisman shares immediately rallied to nearly US$8 per share before selling off slightly to US$7.50.

Five months later, and the deal is much closer to happening. Both Repsol and Talisman shareholders have approved the deal. Alberta courts have ruled that the acquisition is okay; the only thing the companies are waiting on is permission from the feds, who approve any foreign acquisition of size. That doesn’t look to be an issue and both companies expect the deal to close sometime in the next few weeks.

The opportunity

Currently, Talisman shares trade hands on the NYSE for $7.87 each. Based on an $8 purchase price, that’s a projected return of just 1.6%. What’s so exciting about 1.6%?

The thing that makes it exciting is the length of time your money would be locked away. The deal looks to be completed within a few weeks, but let’s be conservative and call it two months. Earning 1.6% over two months is the equivalent of 9.6% over a year. Suddenly, that sounds a little better.

Compare this to my GIC. I currently have a GIC at a major bank that’s locked in for a year. My interest rate is 1.3% for the whole year. Yes, I realize a GIC is much safer than merger arbitrage—it comes with a government guarantee, after all—but the level of risk affects the potential return.

The risk

There’s one huge risk. What happens if the deal doesn’t go through?

The effect on Talisman shares is obvious. They’d sell off, and sell off badly. They’d probably fall to approximately the same level they traded at when the deal was announced, about $4 per share. That’s an immediate 50% haircut.

On the surface, that looks like a pretty poor risk/reward equation. Who goes for a 1.6% gain when the potential loss is 50%?

But it’s not nearly that simple. There isn’t a 50/50 chance that this deal happens. It’s more like a 95/5, or maybe even 99/1 chance that this deal has a happy outcome. If you make 1.6% 99 times and then lose 50% one time, you’re doing pretty well.

The reason why I highlight the Talisman deal is because it’s a pretty straightforward transaction. Repsol has enough cash on its balance sheet to do the transaction, and it’s obvious both companies still want it to happen. There have been no surprises. Talisman is exactly the situation where merger arbitrage is ideal.

There’s an extra wrinkle in the Talisman transaction for Canadian investors. The offer for the company is for US$8 per share, which adds another risk—currency. Based on the current exchange rate shares trade at US$7.87 on both sides of the border. That could change between now and the closing date, affecting returns.

Should you participate in merger arbitrage? I do in select situations, but only when I think the deal has a greater than 95% chance of happening, and usually on smaller stocks where the return will be closer to 3-5%. I believe the Talisman situation has those odds, I’m just not sure 1.6% is enough, especially since that doesn’t consider commissions. So, even though the Talisman merger arbitrage looks to be free money, I’m going to pass.

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Fool contributor Nelson Smith has no position in any stocks mentioned.