Matrix Trading Definition

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Matrix Trading Definition

What Is Matrix Trading?

Matrix trading is a fixed income trading method that seeks for yield curve disparities that an investor may exploit by establishing a bond swap. Discrepancies occur when current rates on a certain kind of bond, such as corporate or municipal, do not match the remainder of the yield curve or its historical norms.

Key Takeaways

  • Matrix trading entails searching for mispricings in fixed-income instruments based on the yield curve.
  • The matrix trader swaps bonds with the hope that the mispricing would correct itself and result in a profit.
  • They might also use the knowledge to simply trade an existing stake for a superior one.
  • Matrix trading is risky since the mispricing may not fix itself or may worsen.

Understanding Matrix Trading

Matrix trading is a bond swapping method that takes advantage of transient changes in yield spreads between bonds of various ratings or classes. A matrix trader may be aiming to benefit merely as an arbitrageur—by waiting for the market to “correct” a yield spread discrepancy—or by trading up for free yield, such as by exchanging debt with identical risks but differing risk premiums.

Matrix pricing may be required for matrix trading. When a fixed income instrument is not widely traded, the trader must assign a value to it since current prices may not necessarily represent the true worth in a sparsely traded market. Matrix pricing is evaluating the price of a bond by examining comparable debt concerns and then using algorithms and formulae to extract a suitable value. If the current price differs from the predicted value, the trader might create a strategy to capitalize on the mispricing.

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Matrix traders ultimately believe that apparent mispricings in relative yields are unusual and will correct quickly. Yield curves and yield spreads may deviate from historical trends for a variety of reasons, but the majority of them will have a similar source: trader uncertainty.

Individual bond classes may also be inefficiently priced for a while, such as when a high-profile corporate default sends shock waves through other corporate debt instruments with comparable ratings. While some bonds may not be immediately impacted by the event, they may be mispriced when traders reorganize holdings or regard the future as unclear. Prices tend to recover to their correct levels once the dust settles.

Matrix Trading Risks

Trading the matrix is not without danger. Mispricings may develop for a variety of reasons and may not return to anticipated levels. A higher-than-expected yield might be the result of selling pressure in a bond connected to the underlying company’s problems that haven’t yet been fully acknowledged.

Furthermore, situations may worsen even if there is no solid explanation for them. Mispricings may be widespread and long-lasting during a market panic. While the mispricing may correct itself, a trader may be unable to sustain the losses in the meanwhile.

Matrix traders benefit when what they predict to happen happens, just like any other technique. If they are incorrect, and the mispricing does not correct itself or continues to move against them, resulting in a loss, they will seek to exit the position while limiting losses.

Example of Matrix Trading

Assume that historically, the difference in interest rates between US short-term Treasuries and AAA-rated corporate bonds has been 2%, while the gap between Treasuries and AA-rated bonds has been 2.5%.

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Company XYZ has a AAA-rated bond with a yield of 4%, whereas rival ABC Corp. has an AA-rated bond with a yield of 4.2%. The gap between the AAA and AA bonds is now just 0.2%, rather than the previous 0.5%. A matrix trader would purchase the AAA-rated bond and sell the AA-rated bond, anticipating a widening of the yield differential (causing the price of the AA bond to fall as its yield rises).

Traders may also look at ranges rather than individual numbers, becoming interested when the spread deviates from the historical range. A trader may see, for example, that the spread between AA and AAA is often confined between 0.4% and 0.7%. If a bond swings dramatically outside of this range, it notifies the trader to the fact that something major is happening, or that there is possible mispricing that may be exploited.

Similar tactics may be used for bonds of varying maturities, economic sectors, and nations or regions.

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