So, THIS Is How Quant Funds Make Money

Take a look into the bond market arbitrage driving billions for quant funds.

“Quant Hedge Funds Reap Windfall During 2022 Market Ructions”

Headlines like this have been commonplace for years; secretive quantitative hedge funds using obscure strategies to generate large returns. Well, thanks to the increasing flow of information, some of the secretive strategies have become not-so-secret.

Let’s unpack convertible bond arbitrage, a major driver of returns in fixed income quant funds.

Before you can understand the arbitrage, you must first understand what convertible bonds are.

Background — Convertible Bonds

Convertible bonds are a type of hybrid security that have characteristics of both bonds and stocks. They offer a fixed interest rate like traditional bonds, but also have the option to convert into a certain number of shares of the issuing company’s stock.

For example, Apple issued $14 billion in convertible bonds in 2021 with a coupon rate of 0.5% and a conversion price of approximately $148 per share. This means that bondholders have the option to convert their bonds into Apple common stock at a price of $148 per share. If the stock price rises above $148, bondholders may choose to convert their bonds into shares, allowing them to participate in the company’s potential growth. If it falls below $148, bondholders can just hold the bond and receive the coupon payments.

The Arbitrage

Convertible bond arbitrage involves buying a convertible bond while simultaneously shorting the underlying stock. The goal is to capture the price difference between the convertible bond and the underlying stock.

Let’s look at an example where IBM issues a convertible bond.

Suppose that IBM issued $1 billion in convertible bonds with a coupon rate of 2%, a maturity of 5 years, and a conversion price of $200 per share. The bond can be converted into IBM common stock at any time during its life.

At the same time, IBM’s common stock is trading at $180 per share. An arbitrageur can arbitrage this by purchasing one convertible bond at face value, $1,000, and simultaneously shorting 5 shares of IBM stock at $180 per share, which is equivalent to $900.

Now, there are three possible outcomes of this trade:

1. Stock Falls: If the stock price remains below $200 per share and the bond reaches maturity, the investor will receive the principal amount plus coupon payments, resulting in a profit of 2% annually. Additionally, the short position can be closed by buying back the 5 shares of IBM common stock at a lower price than the original short sale, resulting in a profit from the price difference.
2. Stock Remains Flat: If the stock price increases moderately or remains flat, the investor will still receive the coupon payments on the bond and close the short position by buying back the 5 shares of IBM stock at a higher price. The profit will be less than the first case, but still positive.
3. Stock Rises: If the stock price rises significantly above the conversion price of $200 per share, the investor could convert the bond into IBM stock and sell the shares at the higher market price to cover the short position. The profit will be larger than the first two cases, as the investor will benefit from the bond’s coupon payments and the appreciation of the stock price.

So, while this is less of an “arbitrage” and more of an advantageously hedged position, it’s clear to see the value it adds to a quantitative portfolio.

If this article piqued your interest, you’d likely enjoy some of my other posts just like this one:

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Happy trading! :)