Asset Swapped Convertible Option Transaction (ASCOT)

Overview

An asset swapped convertible option transaction (ASCOT) is a structured strategy that separates a convertible bond into two distinct components: the fixed‑income (bond/credit) piece and the equity (option) piece. The separation is achieved by using an option on the convertible bond so that one party owns the bond’s credit and coupon stream while another holds exposure to the embedded equity option.

ASCOTs let investors isolate equity exposure without taking on issuer credit risk and are commonly used by hedge funds and convertible arbitrageurs seeking to exploit mis‑pricings between the two components.

How an ASCOT Works

A convertible bond inherently contains two parts: the corporate bond (fixed coupon and principal) and an embedded call option that gives the holder the right to convert into equity.
To create an ASCOT, an intermediary (often an investment bank) structures a transaction that effectively writes (sells) an American call option on the convertible component and sells that option to an investor who wants equity‑like exposure.
The bond portion—with its coupon payments and credit exposure—is sold or swapped to investors willing to assume credit risk (often broken into tranches and sold to multiple parties).
Because the written option sits on an instrument that already has an embedded option, the result is a compound option. The strike and terms typically reflect the costs of unwinding the swap and any carry or financing costs, and an American option can be exercised at any time.

Typical Transaction Flow

Convertible bond holder (trader or fund) wants equity exposure only.
Investment bank buys the convertible bond or intermediates a swap.
Bank writes an American call on the convertible bond and sells it to the original holder (or another investor), isolating the equity payoff.
The bank sells the bond/credit leg to investors who accept credit risk for the fixed returns.
The option holder retains volatility/exposure to the issuer’s equity without direct credit exposure to the bond.

Uses and Market Participants

Hedge funds and convertible arbitrage traders: Acquire the option leg to gain leveraged exposure to equity volatility while avoiding the less attractive bond credit risk.
Bond investors and asset managers: Buy the bond leg to receive coupon income and assume issuer credit exposure.
Investment banks: Act as intermediaries, structure the ASCOT, and manage the swap/write process.

Benefits

Separates credit and equity exposures, allowing specialized investors to hold only the risk they want.
Enables leverage: holders of the option leg can obtain concentrated equity exposure without funding the bond.
Facilitates convertible arbitrage strategies by isolating mis‑pricing between the convertible’s components.

Risks and Considerations

Market volatility: The option leg is typically more volatile and can be highly sensitive to equity price movements.
Counterparty and execution risk: ASCOTs are structured over-the-counter and depend on the intermediary and market liquidity.
Complexity and model risk: Valuation and unwinding costs require sophisticated pricing models; mis-estimation can lead to losses.
Liquidity: Both the option leg and the restructured bond tranches may be less liquid than the original convertible bond.

Key Takeaways

An ASCOT separates a convertible bond into a bond (credit) component and an equity (option) component.
It is created by writing an option on the convertible portion and selling the bond portion to credit investors.
ASCOTs let investors avoid issuer credit risk while retaining equity exposure and are commonly used in convertible arbitrage.
The structure introduces volatility, counterparty, and liquidity risks and requires careful pricing of unwind costs.