What is an Asset Swap Convertible Option Transaction (ASCOT)?

A convertible bond’s option is utilized to divide the bond into its two components, a fixed income piece, and an equity piece, in an asset-swapped convertible option transaction (ASCOT), a structured investment technique. Separating the corporate bond, which has regular coupon payments, and the equity option, which serves as a call option, is more precise.

An investor can access the convertible option through the ASCOT structure without taking on the bond portion of the asset’s credit risk. Convertible arbitrage traders who want to benefit from seeming mispricings between these two components also employ it.

Knowing how to execute asset-swapped convertible option transactions

In what was first offered as a combination instrument—the convertible bond itself—ASCOTs are intricate instruments that let parties assume the roles of equity investor and credit risk buyer/bond investor.

Writing or selling an American option on a convertible bond is an asset-exchanged convertible option transaction. Since the convertible bond already has an embedded equity call option because of the conversion mechanism, this essentially generates a compound option. The holder may exercise the American option at any moment, but the strike price must cover all expenses associated with undoing the asset transfer.

How an ASCOT Functions

Traders of convertible bonds are subject to two different kinds of risk. One is the credit risk that comes with the investment’s bond component. The market volatility of the underlying share price is the third factor that affects whether or not the conversion option has any value.

For our purposes, imagine that the convertible bond trader wishes to concentrate on the equity component of their portfolio of convertible bonds. To accomplish this, the trader sells the convertible bond to an investment bank, which will function as the transaction’s middleman.

By writing a call option on the convertible component of the bond and then selling it back to the convertible bond trader, the investment bank creates the ASCOT. The convertible bond’s bond component, together with its payments, is then sold to a new entity willing to assume the credit risk in exchange for the guaranteed returns. The bond component could be divided into bonds with lesser nominal values and offered to various investors.

Convertible Arbitrage and ACOTS

An asset exchange that removes the credit risk from a convertible bond leaves the option holder with a volatile but possibly extremely lucrative option. Using convertible arbitrage techniques, hedge funds, buy and sell ASCOTs, especially the equity portion. Due to the structure of the compound option within an ASCOT, which excludes the less attractive bond side and its credit risk, hedge funds can readily increase the leverage of their portfolios.

Conclusion

• A convertible bond’s fixed-income and equity halves can be divided via an asset-swapped convertible option transaction, or ASCOT.
• Selling an American call option on the convertible bond issuer’s shares at a strike price that covers the cost of unwinding the strategy results in an ASCOT.
• ASCOTs offer prospects for convertible arbitrage methods and allow investors to reduce the credit risk associated with convertibles.