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One asset class that gets referenced from time to time in histories of quantitative finance is Japanese warrants. If you're reading about someone who was writing code in order to identify and exploit miscellaneous trading opportunities in the late 1980s and early 1990s, there's a very good chance that they traded these. When Ed Thorp shut down his fund, he switched to mostly seeding other funds but also trading Japanese warrants. D.E. Shaw traded them, and John Overdeck ran that business for them before co-founding Two Sigma. In the early 90s, Paloma was doing the trade, too, as we know thanks to later litigation. Ken Griffin listed it as one of Citadel's early moneymakers. It was a popular enough trade that some allocators heard about it and brought it in-house, so Harvard was in on it, too. The Japanese warrant trade even adds some color to a famous financial scandal; Barings, at the time the UK's oldest merchant bank, collapsed after a rogue trader named Nick Leeson hid enormous losses from speculating in derivatives in Asia. The usual question with rogue traders is: why didn't management notice that one of their traders was so suspiciously profitable, and part of the answer is that they were actually pretty used to the idea that people trading derivatives in Asia could make substantial low-risk profits.

So, in that corner of the world, everyone was doing the trade, and everyone knew it was lucrative.

So: why?

The basic story is that in the late 1980s, it got trendy in Japanese corporate finance circles to issue low-interest bonds with warrants attached. They were aware that their shares were expensive, but also aware that they could do a carry trade: issue dollar-denominated bonds with warrants, swap the dollars into yen, and use them for whatever the company needed capital for—real estate speculation, domestic financial engineering, maybe even running the business!

Part of the way the equity-linked securities business works is that common-sense intuitions and probabilistic ones collide; it might strike a CFO as intuitive that after the massive runup of the 1980s, their stock couldn't keep going up forever, and that seeing those warrants go in-the-money was a nice problem to have. What wasn't as intuitive, from the corporate finance side, was that it was possible to buy the warrants, short the stock to neutralize exposure to its movements, and then make money if the implied volatility was low. If there were lenders who wanted straight debt and would treat the warrant as something to be sold off to a specialized investor, and if the ultimate borrowers also weren't carefully valuing the warrants, that meant that there were two layers of fairly price-insensitive sellers.

And so, in stepped the buyers.

There are many times when there's a lot of uninformed supply or demand in some market, but for many trades that just raises the question of timing. If you'd looked at dot-com financials and Internet penetration in 1998, you could have correctly concluded that all the consumer-facing names were overpriced and that the B2B ones who had them as customers were both overpriced and over-earning. Over the next two years and change, the Nasdaq tripled. You can be right that buyers are overpaying and still underestimate how many more people there are who are willing to overpay, and how long they'll remain willing.

But if they're selling a derivative, what they're really selling is single-stock volatility, and that volatility can be isolated. If you put on the position, and more companies issue more underpriced warrants, that's only a problem insofar as your competitors sell positions similar to yours in order to buy the next one. But market inefficiency is just another way of saying that that doesn't happen, or at least doesn't happen fast.

The arbitrage persisted in part because of enormous supply, and in part because it was somewhat complicated: a typical trade would involve buying a dollar-denominated detached warrant in London, and shorting the corresponding yen-denominated equity in Tokyo. And the hours these markets were open didn't overlap.

Japanese stocks massively underperformed during the era of mass bonds-with-warrants sales. What the warrant sellers saw was that they'd sold the right to buy their shares at high prices, and the shares never attained those prices. Free money! But it's free money in the same sense that if you sell earthquake insurance and there isn't an earthquake that year, you made a profit; it's all a question of pricing the risk correctly. The quants executing this trade ended up being persistently short Japanese equities, which went down a lot, and long Japanese equity volatility, which tended to rise during market declines. They weren't making a purely directional trade, but those moves describe roughly how they got paid.

This trade went away as Japanese companies got less aggressive in capital markets generally. But the trade was big enough that it could feed plenty of quantitative strategies. There's a purely inductive version of systematic investing, where all you do is look for persistent patterns or build a derivatives valuation model that tells you what's mispriced and how to hedge out most of the risk. But those mispricings can only persist if they have a reason to exist in the first place; a better way to look at it is that systematic investing is the implementation of some high-level view about irrational market actors. It's a lot safer to have a solid why behind the statistical what, especially when the why might change.

These kinds of discrepancies still exist, generally at a smaller scale. Corporate borrowers have gotten more sophisticated, but the big difference is that capital has gotten more mobile. Zero-interest convertible bonds follow very similar logic to the Japanese bond-and-warrant product; they're a way to borrow cheaply, and then give lenders equity if and only if the stock goes up. And they tend to get bought almost entirely by specialists who are buying the convert, hedging out the stock price risk (and the credit risk for the debt piece) and capturing what's now a smaller spread. If convertible bond issuance goes up, pods will put more capital into the strategy, and funds that specialize exclusively in this trade will also raise more capital. So the same kind of trend happens, but the market absorbs it faster—and many of those pods will be descended, either as a corporate entity or based on who learned quantitative finance from whom—from some of those early Japanese warrant traders.

Quantitative investing is frequently part of the Diff beat because it represents the point at which repeated qualitative judgments can be turned into firmer rules. Some posts touching on this:

• Value investing is still real, but the systematic version is harder to execute ($).

• A look back at the quant quake of 2007.

• We built a market simulation in which different agents run different strategies, featuring factor crowding and more.

• When you're using a systematic approach, you often want to start with the premise that the market is efficient and then look for reasons it wouldn't be ($).

• Reflections on Renaissance Technologies.

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