The Delaware Chancery Court ruling by Vice Chancellor Morgan Zurn threw a monkey wrench into the AMC Entertainment Holdings Inc (AMC) and AMC Preferred Equity Units (APE) arbitrage trade by not agreeing to the proposed class action settlement. A revised settlement agreement has been presented to the court in hopes of an imminent settlement.

AMC Entertainment spun-off one APE share for every share of common stock in August 2022 which could be converted to one AMC share sometime in the future. The immediate price discrepancy between the two securities created an arbitrage opportunity. On the first day of APE trading there was a $4.46 spread on the closing price of the two stocks (AMC @ $10.416 and APE @ $6.00). Arbitrageurs could sell the more expensive AMC shares and buy the cheaper APE shares in anticipation that the two stock prices would be the same when the APE shares were converted into AMC shares.

Profitability of arbitrage trades are dependent on four revenue\expense streams: mark-to-market profits\losses on the long leg of the trade; mark-to-market profits\losses on the short leg of the trade; stock borrow costs on the short leg of the trade; and margin costs on the net broker financing of the trade.

In this analysis we will still assume that one share of APE turns into one share of AMC and the 13% proposed share premium to be awarded to AMC shareholders is still just a proposal and not part of the original arbitrage calculation. If AMC short sellers do have to buy and deliver an additional 13% of their short position to their stock lenders it would add an additional $76,050 cost to the trade as of yesterday’s closing prices.

Market timing is always one of the major factors in the profitability of any stock trading, but especially in arbitrage trading where stock borrow financing costs and margin costs eat into expected Alpha every day, even on weekends!

Assumptions for this mathematical arbitrage exercise are: long 100,000 shares of AMC; short 100,000 shares of APE; daily calculation of mark-to-market profits\losses on the long and short side of the trade based on closing stock prices; daily calculation of stock borrow costs based on S3 Offer Rate; daily calculation of margin costs

of the trade based on 15% margin requirement and OBFR -25bps financing cost; the final arbitrage spread equal to the difference between the closing AMC & APE stock prices *100,000 shares; and 13% AMC premium is the value of 13% of the shorted shares at the closing AMC stock price.

Arbitrage trades usually produce negative returns until the stock price of the long and short shares trend towards equality. And these returns fluctuate tremendously depending on when the arbitrage trade is executed, especially if the stock prices of the two stocks are volatile and there are high stock borrow financing costs.

The following chart calculates the daily mark-to-market profit\loss of both the 100,000 share long APE and 100,000 share short AMC holdings, the daily stock borrow financing costs for the short AMC holdings and the net margin cost charged by the Prime Broker for putting on the trade. The stock borrow costs and margin costs can vary significantly by Prime Broker and type\quality of the hedge fund\investor putting on the trade.

The totals by Trade Date are the accumulated revenues and expenses from the Trade Date through 7/24/2023:

Losses on the AMC and APE holdings varied from a loss of $(593,238) if the arbitrage was executed at the beginning of January 2023 to a loss of $(185,483) if the arbitrage was executed at the beginning of May 2023.

In order to estimate a “final” profit and loss for the AMC\APE arbitrage trade we assume the stock prices for both legs of the trade are equal at the conversion of APE to AMC stock. The calculation is (AMC’s closing stocks price – APE closing stock price) * 100,000 shares. Using the closing stock prices as of 7/24/2023 the calculation is ($5.85 - $1.80) * 100,000 shares = $405,000 profit.

Daily margin also needs to be posted to the Prime Broker to support the arbitrage transaction. The basic calculation is 15% of the market value of both the long and short legs for the trade, calculated daily with variation margin added or subtracted daily.

After including the Arb Profit and Loss Spread the return on average margin posted varies from a negative return of -185.66% return if the arbitrage was executed at the beginning of January 2023 to a positive return of +230.59% if the arbitrage was executed at the beginning of May 2023.

If the terms of the APE conversion are amended and includes a 13% stock “dividend” for all AMC long shareholders, the AMC short sellers will be liable to deliver those shares to their stock lenders. 100,000 short shares * 13% “stock dividend” * $5.85/share = $76,050 additional financing cost added on to the short side of the arbitrage.

After including the 13% AMC stock dividend premium the return on average margin posted varies from a negative return of -260.66% return if the arbitrage was executed at the beginning of January 2023 to a positive return of +151.78% if the arbitrage was executed at the beginning of May 2023.

Trade entry\exit point timing and duration are two of the main drivers to determine the profitability of an arbitrage trade. Traders who executed an AMC – APE arb trade in August through November of 2022 and January through February of 2023 and kept the trade open would have incurred net losses and have probably closed down their trades at some point. Traders who executed an AMC – APE arb trade in December of 2022 and March through July of 2023 and kept the trade open would have incurred net profits and have kept their positions open and are waiting for the conclusion of the judicial proceedings regarding the APE conversion to collapse their longs and short legs.

Timing is everything, if you entered the AMC – APE arb trade on December 22, 2022 when the end of day spread was $7.19 (the largest spread between the two securities) and exited your arb trade on Dec 27 when the end of day spread was $2.12 (the smallest spread between the two securities) you would be up $494 thousand in net-of-financing mark-to-market profits, a 487% return on average collateral posted for the trade in less than a month. Trade identification and execution is what makes a profitable trade, which although difficult can be much more fun than a barrel of monkeys.

This analysis is a pared down view of the AMC- APE arbitrage trade using closing stock prices as the trade execution cost basis for the calculations. Different trade executions for the long or short side of the trade would alter the profit and loss profile of the arbitrage but the analysis highlights the fact that high stock borrow costs and the uncertainty of the final details of the arbitrage conversion can turn what was an obvious arbitrage opportunity into a very risky transaction.

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