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with almost no premium and hedged 100 percent requires almost no capital to set up. The position can generate very high static returns and be quite profitable if the underlying common stock drops significantly. While the leverage is nearly infinite, the credit and equity risks of such a position are de minimus. "We believe that reasonably leveraged and well-hedged arbitrage portfolios are considerably less risky than unhedged, outright equity portfolios."

The amount of leverage used is determined qualitatively and quantitatively. Stark explains, "The higher credit quality of the portfolio means that more leverage can be taken. If a significant portion of the convertible portfolio is asset swapped or otherwise default protected, then there is limited credit risk. We can create quality positions without the credit risk of companies going bankrupt."

Stark discusses how they build in macro considerations. For example, when arbitrage spreads tighten, they are more cautious. If the equity markets are speculative and frothy, such as in 1987 and first quarter of 2000, pricing can be wild. In those situations, positions will be heavily hedged and generally carry lower leverage since the risk of a significant market correction is higher. Often in such corrections, arbitrage spreads widen, causing mark-to-market pain if not compensated through higher hedge ratios and lower leverage.

Stark says they try to hedge most risks in the portfolio and do so more than the typical equity hedge fund. "We are typically overhedged on a theoretical basis. Generally, when the equity markets are rising, we will do better than theory predicts we should because the outright community, in an effort to keep up with their benchmarks, will buy convertibles at expensive premiums. Conversely, when the equity markets are falling, convertibles will do worse than they should because the outright community, which has no downside protection, is selling convertibles cheaper than theory says they should. We offset this skew by overhedging."

The firm's currency exposure is fully hedged but the degree to which interest rate exposure is hedged is variable. This is because the correlation between convertible pricing and interest rates often is much less than theory predicts. Moreover, the costs of running a continuous full-interest hedge can be quite high and over time is likely to be a losing proposition. Thus, in the United States, the firm is typically only partially hedged. On the other hand, when conditions warrant, they