What Is an Asset Swapped Convertible Option Transaction (ASCOT)?
Let me explain what an asset swapped convertible option transaction, or ASCOT, really is. It's a structured investment strategy where you use an option on a convertible bond to split that bond into its two main parts: the fixed-income piece and the equity piece. Specifically, you're separating the corporate bond with its regular coupon payments from the equity option that acts like a call option.
With this ASCOT setup, you as an investor can get exposure to just the option part of the convertible without dealing with the credit risk that comes from the bond side. Convertible arbitrage traders also use it to make money from what looks like mispricings between these two components.
Key Takeaways
- An asset swapped convertible option transaction, or ASCOT, is a way to separate the fixed-income and equity components from a convertible bond.
- An ASCOT is constructed by selling an American call option on the stock of the convertible bond issuer at a strike price that accounts for the cost of unwinding the strategy.
- ASCOTs let investors remove the credit risk from convertibles and provide opportunities for convertible arbitrage strategies.
Understanding Asset Swapped Convertible Option Transactions
ASCOTs are complex instruments, and they let different parties take on the roles of equity investor or credit risk buyer in what started as a single combined product—the convertible bond itself.
You create an ASCOT by writing, or selling, an American option on the convertible bond. This turns it into a compound option because the convertible already has an embedded equity call option from its conversion feature. The holder can exercise this American option anytime, but the strike price has to cover all the costs of unwinding the asset swap.
How an ASCOT Works
Convertible bond traders face two kinds of risk: the credit risk from the bond part and the market volatility on the underlying share price, which affects the conversion option's value.
Suppose you, as a trader, want to focus on the equity side of your convertible bond portfolio. You sell the convertible bond to an investment bank, which acts as the middleman.
The bank then structures the ASCOT by writing a call option on the convertible's equity portion and selling it back to you. They take the bond portion with its payments and sell it to another party willing to handle the credit risk for the fixed returns. Sometimes, they break the bond into smaller pieces and sell to multiple investors.
ASCOTs and Convertible Arbitrage
Once you strip the credit risk from a convertible bond via an asset swap, what's left for the option holder is a volatile but potentially high-value option. Hedge funds buy and sell these ASCOT equity portions as part of their convertible arbitrage strategies.
These funds can ramp up leverage in their portfolios easily because of the compound option in an ASCOT, ditching the less exciting bond side and its credit risk altogether.
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