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cash flow from the interest or dividends from the convertibles and rebates on the short sale proceeds. Second is making money from volatility. Typically, to maintain market neutrality, they must short more stock when stocks rise and buy back some of the shorts when stocks fall. Thus, they capture trading profits from volatility while maintaining market neutrality. In addition, when the markets are volatile, more inefficiencies occur. Third is mispricing (i.e., buying below theoretical value and selling either when the convertible or risk arbitrage spread reaches fair value or the risk arbitrage deal closes).

NET EXPOSURE

Net exposure varies considerably, but on average shorts are 70 to 90 percent as big as the longs. Stark feels that it is not a good indicator of their true exposure since you could be quite short with the short side being only 70 percent of the longs. Convertibles move down more slowly than do equities. Furthermore, cash tender offers have no short side.

Stark thinks of exposure in terms of how the hedge ratios compare to what quantitative models say their theoretical deltas (i.e., hedge ratios) are. On a portfolio basis, they are theoretically heavy 5 to 10 percent and sometimes more. They do this because there tends to be a skew in arbitrage positions. They tend to do better than theory predicts when stocks are rising strongly and worse than predicted when stocks are falling significantly.

LEVERAGE AS A TOOL

"Leverage is a tool that needs to be used carefully and the right way. It varies based on the macro environment and the degree of undervaluation of the portfolio." Stark's range is between 1.5:1 and 7:1. "We adjust the leverage downward when the macro environment becomes more of a concern or the degree of arbitrage mispricing diminishes, and tend to increase leverage when the macro environment becomes friendly or the degree of arbitrage mispricing increases."

Stark says the usual thinking of investors is that greater leverage means greater risk. But in arbitrage that correlation breaks down. Stark says that situations can exist where leverage is very high but risk is quite limited. For example, a convertible arbitrage position involving a bond