The Power of Asset Swapped Convertible Option Transactions (ASCOT)
An asset swapped convertible option transaction (ASCOT) is a sophisticated investment method where a convertible bond is divided into two main components: a fixed-income piece and an equity piece. This division is achieved via an option on the convertible bond itself, separating the bond with its regular coupon payments from the stock’s call option.
The ASCOT arrangement enables investors to access the option component of a convertible bond without bearing the credit risk associated with the bond. It also serves the purposes of convertible arbitrage traders who aim to capitalize on perceived discrepancies between these two elements.
Key Takeaways
- Component Separation: An ASCOT slices fixed-income and equity segments from a convertible bond.
- Implementation: Established by selling an American call option on the stock of the convertible bond issuer while considering the unwinding strategy cost.
- Risk Management: Allows the exclusion of credit risk from convertibles and offers prospects for convertible arbitrage.
Understanding Asset Swapped Convertible Option Transactions
ASCOTs are intricate investments allowing one party to play the role of an equity investor and another to bear the credit risk, initially combined within a convertible bond.
Creating an ASCOT involves writing (selling) an American option on the convertible bond, forming a compound option, since the convertible bond inherently includes an embedded equity call option due to its conversion element. The holder of the American option can exercise it anytime, though the strike price should cover all associated costs of unwinding the asset swap.
Mechanics of ASCOT
Convertible bond traders face two primary risks: bond’s credit risk and market volatility affecting the bond’s underlying share price, impacting the conversion option’s value.
To focus solely on the equity aspect, a convertible bond trader sells the bond to an intermediary investment bank. The bank structures the ASCOT by creating a call option on the bond’s convertible part and sells it to the bond trader. The bond’s fixed-income segment, along with coupon payments, is sold to another entity ready to handle the credit risk for fixed returns. This bond part may be further subdivided and sold to multiple investors.
ASCOTs and Convertible Arbitrage
When a convertible bond’s credit risk is stripped away through an asset swap, the remaining option is volatile but can be highly valuable. ASCOT’s equity part is traded by hedge funds using convertible arbitrage strategies. These hedge funds can significantly leverage their portfolios due to the ASCOT’s compound option, excluding the less lucrative bond side and its credit risk from consideration.
Related Terms: Convertible Bond, Call Option, Convertible Arbitrage, American Option, Compound Option, Embedded Option.
