Thorp Quantitative Ch. 3: Statistical Arbitrage & Convertible Bond Hedging

"Markets are filled with local pricing inefficiencies. You don't need to forecast the global economy; you only need to simultaneously exploit 200 small pricing anomalies while neutralizing systematic risk." — Edward O. Thorp

The World's First True Quantitative Hedge Fund

In 1969, Edward Thorp co-founded Princeton Newport Partners (PNP). Over nearly two decades, PNP produced a compounded net return of over 19% annualized without a single losing year.

PNP's operational core relied on Convertible Bond Arbitrage and Statistical Pairs Trading.

Convertible Bond Decomposition

$$V_{CB} = V_{Bond} + V_{Option} - V_{Call}$$

A convertible bond behaves like a corporate bond floor coupled with an embedded call option. By buying undervalued convertibles and shorting $\Delta$-adjusted shares of the underlying equity, PNP captured coupon yield, short interest rebates, and volatility expansion while immunizing the portfolio against directional equity crashes.

Tactical Rules

1. Maintain Positive Carry: Ensure structural yield exceeds borrowing costs.
2. Credit Screen: Eliminate bankruptcy risks using Altman Z-score filters.
3. Systematic Z-score Mean Reversion: Enter statistical pairs at $|Z| > 2.0$ and exit at $|Z| < 0.5$.