What is an ASCOT (Asset Swapped Convertible Option Transaction)?
– Short definition: An ASCOT is a structured trade that separates a convertible bond into two parts — the credit/fixed‑income piece (the corporate bond with coupon payments) and the equity option piece (the conversion right, which behaves like a call option). The separation is achieved by an asset‑swap style arrangement in which one party takes the bond’s cash flows and credit exposure, while another holds the option on conversion.
Key jargon (defined)
– Convertible bond: a corporate bond that can be converted into a fixed number of the issuer’s shares under prescribed terms.
– Embedded option: the conversion feature inside a convertible bond that gives the holder a call‑like right on the issuer’s equity.
– Asset swap: a transaction that effectively transfers cash‑flow and credit exposure of a bond to one party in exchange for payment and a derivative contract that replicates the bond’s alternative economic exposures.
– American option: an option that can be exercised at any time up
to expiration. (Right to exercise at any time up to and including the expiration date.)
– European option: an option that can be exercised only at its expiration date.
– Bermudan option: an option that can be exercised on specified dates (between American and European styles).
– Conversion ratio: the fixed number of common shares that one convertible bond can be exchanged for.
– Conversion price: the effective share price implied by the bond’s par value divided by the conversion ratio (Conversion price = Par value / Conversion ratio).
– Conversion value (parity): current stock price × conversion ratio. This is the immediate value of converting the bond into shares.
– Conversion premium: how much the convertible bond trades above parity; calculated as (Convertible price − Conversion value) / Conversion value.
– Asset‑swap spread: the additional spread (over a reference floating rate) that an investor receives when a fixed‑rate bond’s cash flows are swapped into floating‑rate cash flows. It reflects credit and liquidity characteristics of the bond.
– Credit exposure: the risk that the bond issuer will default and fail to pay coupons or principal.
– Basis/basis risk: residual mismatch between the separated bond cash flows and the option’s payoff that may cause imperfect hedging after the split.
How an ASCOT (asset‑swapped convertible) works — step by step
1. Start point: a convertible bond exists. It has regular fixed coupons, principal at maturity, and an embedded conversion option into equity.
2. Objective: split (separate) the bond’s fixed‑income cash flows and credit exposure from the equity upside (the embedded option). Each piece is sold/allocated to a different counterparty.
3. Asset‑swap leg: the party taking the bond cash flows enters into an asset‑swap to convert the fixed coupons and principal into a floating‑rate exposure plus an asset‑swap spread. That party effectively holds the straight‑bond economics and issuer credit risk.
4. Option leg: the other party purchases the embedded conversion option (or enters a derivative that replicates it). This party obtains equity‑like upside and typically hedges delta exposure via shorting the underlying shares or other derivatives.
5. Settlement and collateral: trades are usually documented with ISDA/CSA terms; collateral and margin mitigate counterparty credit risk.
6. Net effect: the original convertible is economically reproduced by combining the two new positions, but with exposures owned by different counterparties who value them differently (for regulatory, accounting, or investment‑strategy reasons).
Simple numeric illustration
Assume: par = $1,000; coupon = 5% annually; conversion ratio = 20 shares; current stock price = $45.
– Conversion value = 20 × $45 = $900.
– Suppose the market price