Asset Swapped Convertible Option Transaction

An asset swap convertible option transaction (ASCOT) is a financial transaction where an investor exchanges a fixed-income instrument in return for a convertible bond. This transaction type allows investors to merge the benefits from a fixed-income instrument with the possibility of capital growth through the conversion option.

An ASCOT integrates the features of an asset swap and a convertible option. It enables investors to customize their experience with fixed-income assets and equity financial instruments to meet their investment goals. As a result, the investors can earn profit from both fixed-income and equity instruments.

• An asset swap convertible option transaction (ASCOT) is a financial transaction where an investor can exchange their existing fixed-income instrument for a convertible bond. This transaction combines the elements of a convertible option and an asset swap.
• This transaction's terms and conditions can be customized according to the involved parties' specific requirements. As a result, an ASCOT can be a valuable tool through which the involved parties can meet their investment goals.
• The conversion option comes with a predetermined timeframe, and the investor can exercise the option during the stipulated period.

An asset swap convertible option transaction (ASCOT) is a trading method where an investor can combine an asset swap and a convertible option. For example, an investor trades a fixed-income financial instrument for a convertible bond with a conversion option in this transaction type. This implies that the investor can convert the bond into a specified number of the issuing company's common shares at a particular conversion price.

An ASCOT enables investors to generate income from the fixed-rate financial instrument while having the opportunity for capital enhancement through the equity conversion option. They can exercise the conversion option if the share price surpasses the conversion price and convert the bond into the issuing company's common shares. As a result, they would earn profit from the rise in the asset's value. Generally, the conversion option comes with a predetermined exercise period, and the investors can exercise that conversion within the expiration period.

The ASCOT structure is as follows:

#1 - American Call

An American Call option offers investors the right to purchase an asset at a specified price at any time within the option's expiration period. In an ASCOT, this option implies the concerning convertible bond. The ASCOT investor can purchase the convertible bond back if and when they want to convert it to stocks. However, they must pay a floating strike price to buy back the convertible bond. A floating strike price means that the strike is decided when the option's owner chooses to exercise it.

#2 - Asset Swap

An asset swap implies exchanging an asset for cash and swapping cash flows to maintain exposure to that asset. In an ASCOT, the convertible bond's owners are the swap sellers as they sell the convertible bond to the investor or the swap buyer. During the bond's lifespan, the swap buyer passes the bond's coupons to the swap seller and receives a floating rate in return.

The participants in an ASCOT are as follows:

• Investor: This entity is the party seeking to participate in the asset swap transaction. They own an existing fixed-rate financial instrument and want to exchange it for a convertible bond with a conversion option.
• Counterparty: This entity is the party that participates in the asset swap transaction with the investor. They hold the convertible bond and want to exchange it for the fixed rate instrument.
• Issuing Company: This company implies the organization initially issuing the convertible bond. Usually, this company is publicly traded, and its shares come with a conversion option. 

An ASCOT valuation comprises assessing the components' worth, including the fixed rate instrument, the conversion option, and any other concerning factors. Involved parties can value it by applying a tree model as is done with options because an ASCOT is an option to purchase back the convertible bond. The process consists of building three trees where one tree implies the stock price to account for when the bond is called. The second suggests valuing the convertible bond, and the third implies the ASCOT. However, the valuation process may vary according to the transaction's attributes, terms, and prevailing market conditions during the valuation period.

 Let us understand this concept with the following examples:

Example #1

Suppose a company named Dreamworks Ltd. purchased a convertible bond in the market for $5,000. It engaged in an asset swap with another organization named Funzone Company. Dreamworks Ltd. intended to sell the convertible bond to Funzone Company at $4500. Instead, it entered an exchange where Dreamworks Ltd. would receive fixed payments from Funzone Company equivalent to the bond coupons. It would also pay a floating rate to Funzone Company. Both companies mutually decided that Dreamworks Ltd. would have the right to purchase the convertible bond back from Funzone Company in the future. This is an example of ASCOT.

Example #2

Suppose John holds a fixed-rate bond issued by Futureworks Company worth $1000 that pays a 5% fixed interest rate per year and matures in 4 years. Alex holds a $1,000 convertible bond issued by Nomad Company which pays a 3% fixed interest rate per year and matures in 4 years.

The convertible bond allows Alex to convert the bond into 1,000 common shares of Nomad Company at any time within the bond's term, with a $100 conversion price per share. John and Alex agree on an ASCOT where John wants to benefit from having the option to own Nomad Company's shares, while Alex wants to earn a higher fixed interest rate. As a result, John transfers his Futureworks Company's fixed-rate bond to Alex and receives Nomad Company's convertible bond in exchange.

Post the transaction, John got the opportunity to convert Nomad Company's bond into 1,000 common shares of the company at any time within the bond's four years maturity period. He will also receive a 3% fixed interest per year until the bond's maturity. On the other hand, Alex will receive a 5% fixed interest rate until the Futureworks Company's bond matures in 4 years. Again, this is an example of ASCOT.

This has been a guide to what is Asset Swapped Convertible Option Transaction (ASCOT). Here we explain its structure, participants, valuation, and examples. You can learn more about it from the following articles –

• Reverse Convertible Note
• Convertible Debt
• Convertible Preferred Stock