Page 232

An asset swap is the process by which the manager sells out the bond component of the convertible bond, leaving only the equity option of the convertible (plus an option to call back the bond component from the asset swap buyer). The asset swap buyer is interested in buying the asset swap for yield, and is buying the straight bond without any call on the equity. Stark likes to asset swap because it eliminates any credit risk associated with owning the convertible.

Based on 1998's experience, Stark Investments narrowed position limits even more. Formerly the firm would generally risk 4 percent in any one position. Today, those limits are 3 percent for convertible arbitrage and 2 percent for risk arbitrage holdings.

MEMORABLE TRADES/MOTIVATION

When discussing memorable trades, Stark has a long list going back to 1987. He talks about intermarket trading of Nikkei puts back in the late 1980s as an example. This was a period in which the Japanese equity market was in the process of crashing with violent day-to-day swings in the Nikkei index (the Japanese equivalent of the Dow Jones Industrial Average). North American investors were clamoring for ways to profit from the debacle. A variety of U.S. and Canadian under-writers met this demand by issuing Nikkei puts. Each put was a security whose value was determined by the price of the Nikkei; the lower the Nikkei went the greater the value of the put. The price of each security was determined by some form of trailing average of a series of closing prices for the Nikkei.

Complexity was added by the fact that these puts traded when the Nikkei was closed, had a variety of strike prices, involved up to three different currencies and cross-currency rates, and differed in key respects regarding the manner of converting the securities into cash. Through mathematical formulas, as well as real-time pricing and currency feeds, one could equalize the securities. Huge disparities in prices simultaneously occurred between different classes of these securities within a market and between markets. This was because trading was dominated by speculators emotionally betting on the next day's move in the Nikkei and because these investors were not cognizant of the existence of all of the other puts available or lacked the means or understanding to quickly equalize them or to borrow the securities for