Hi,How would you calculate a VaR on a Risk Arbitrage position, given the probability of succes of the merger and the Downside of the target ?Thanks in advance for your help.Best regards,

Forget about VaR, you're dealing with a synthetic optionality here. Better to stress test it by takin your (prob that deal breaks)*max loss(downside on target) + (prob that deal breaks)*max loss(upside on acquirer) = expectation of toal loss on a busted deal. Remember that this "risk arb"spread is sort of a synthetic "short strangle" so the shorts will get squeezed and the longs will b forced to liquidate--all at the same time--so there's mucho path-dependence here for ya. U really only care about 2 states: Deal Closes or Deal is Busted. The intermediate risks are not very meaningful.

Thank you for your quick reply Silver Surfer. I share your point of view.Do you agree that if the Probability of Failure is 1%, you get exactly a measure of VaR 99% 1 Day with the Stress Test you suggest ? What if I have 10% for the Probability that the deal breaks ?I think most banks do not well integrate an appropriate solution to the problem that satisfies the Regulator's will. But what transformation should be applied to calibrate a 1% risk that has only two states (success / failure) : call it VaR or add-on or whatever... ?? Any idea for this ?

I think the catch here is arriving at the probability and simulation does not help.So , from a regulatory perspective it is highly difficult to justify any probability measure.How do u get the 1% or 10%.