Asset Swapped Convertible Option Transaction (ASCOT)
What Is an Asset Swapped Convertible Option Transaction (ASCOT)?
An asset swapped convertible option transaction (ASCOT) is a structured investment strategy wherein an option on a convertible bond is utilized to separate a convertible bond into its two parts: a fixed income piece and an equity piece. All the more specifically, the parts being separated are the corporate bond with its ordinary coupon payments and the equity option that capabilities as a call option.
The ASCOT structure permits an investor to gain exposure to the option inside the convertible without assuming on the acknowledgment risk addressed by the bond part of the asset. It is additionally utilized by convertible arbitrage traders seeking to profit from apparent mis-pricings between these two parts.
Understanding Asset Swapped Convertible Option Transactions
ASCOTs are complex instruments that permit parties to play the job of equity investor and credit risk purchaser/bond investor in what was initially sold as a combined instrument — the convertible bond itself.
An asset swapped convertible option transaction is finished by composing (selling) a American option on the convertible bond. This basically makes a compound option, as the convertible bond as of now accompanies a embedded equity call option itself due to the conversion feature. The American option can be practiced by the holder whenever, however the strike price paid must incorporate every one of the costs of loosening up the asset swap.
How an ASCOT Works
Convertible bond traders are presented to two types of risk. One is the credit risk inborn in the bond portion of the investment. The other is the market volatility on the share price of the underlying, as it influences whether the conversion option has any value.
For our motivations, let's accept the convertible bond trader needs to zero in on the equity point of their convertible bond portfolio. To do this, the trader offers the convertible bond to an investment bank, which will be the intermediary in the transaction.
The investment bank structures the ASCOT by composing a call option on the convertible portion of the bond and selling it back to the convertible bond trader. The bond portion of the convertible bond with its payments is then sold to an alternate party who is prepared to assume on the praise risk in return for the fixed returns. The bond part might be broken down into more modest denomination bonds and sold to different investors.
ACOTS and Convertible Arbitrage
At the point when a convertible bond is stripped of its credit risk through an asset swap, the option holder is left with an unpredictable — however possibly truly valuable — option. ASCOTs, specifically the equity portion, are bought and sold by hedge funds utilizing convertible arbitrage strategies. Hedge funds are able to handily increase their portfolios' leverage on account of the idea of the compound option inside an ASCOT, leaving the less lucrative bond side and its credit risk out of the equation.
Features
- An asset swapped convertible option transaction, or ASCOT, is a method for isolating the fixed-income and equity parts from a convertible bond.
- An ASCOT is built by selling an American call option on the stock of the convertible bond issuer at a strike price that accounts for the cost of loosening up the strategy.
- ASCOTs let investors eliminate the credit risk from convertibles and gives opportunities to convertible arbitrage strategies.
