Risk arbitrage in the Nikkei put warrant market of 1989-1990

This paper discusses the Nikkei put warrant market in Toronto and New York during 1989-1990. Three classes of long term American puts were traded which when evaluated in yen are ordinary, product and exchange asset puts, respectively. Type I do not involve exchange rates for yen investors. Type II, called quantos, fix in advance the exchange rate to be used on expiry in the home currency. Type III evaluate the strike and spot prices of the Nikkei Stock Average in the home currency rather than in yen. For typically observed parameters, type I are theoretically more valuable than type II which in turn are more valuable than type III. In late 1989 and early 1990 there were significant departures from fair values in various markets. This was a market with a set of complex financial instruments that even sophisticated investors needed time to learn about to price properly. Investors in Canada were willing to buy puts at far more than fair value based on historical volatility. In addition, US investors overpriced type II puts fixed in dollars rather than the type I’s in yen. This led to cross border and US traded (on the same exchange) low risk hedges. The market’s convergence to efficiency (that is, all puts priced within transaction cost bands) took about one month after the introduction of the US puts in early 1990 leading to significant profits for the hedgers.