What Is an Asset Swapped Convertible Option Transaction (ASCOT)?

An asset swapped convertible option transaction (ASCOT) is a structured investment strategy in which an option on a convertible bond is used to separate a convertible bond into its two components: a fixed income piece and an equity piece. More specifically, the components being separated are the corporate bond with its regular coupon payments and the equity option that functions as a call option.

The ASCOT structure allows an investor to gain exposure to the option within the convertible without taking on the credit risk represented by the bond part of the asset. It is also used by convertible arbitrage traders seeking to profit from apparent mis-pricings between these two components.

Understanding Asset Swapped Convertible Option Transactions

ASCOTs are complex instruments that allow parties to take the role of equity investor and credit risk buyer/bond investor in what was initially sold as a combined instrument — the convertible bond itself.

An asset swapped convertible option transaction is done by writing (selling) an American option on the convertible bond. This essentially creates a compound option, as the convertible bond already comes with an embedded equity call option itself due to the conversion feature. The American option can be exercised by the holder at any time, but the strike price paid must include all the costs of unwinding the asset swap.

How an ASCOT Works

Convertible bond traders are exposed to two types of risk. One is the credit risk inherent in the bond portion of the investment. The other is the market volatility on the share price of the underlying, as it impacts whether or not the conversion option has any value.

For our purposes, let’s assume the convertible bond trader wants to focus on the equity angle of their convertible bond portfolio. To do this, the trader sells the convertible bond to an investment bank, which will be the intermediary in the transaction.

The investment bank structures the ASCOT by writing 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 a different party who is prepared to take on the credit risk in return for the fixed returns. The bond component may be broken down into smaller denomination bonds and sold to multiple investors.

ACOTS and Convertible Arbitrage

When a convertible bond is stripped of its credit risk through an asset swap, the option holder is left with a volatile — but potentially very valuable — option. ASCOTs, specifically the equity portion, are bought and sold by hedge funds employing convertible arbitrage strategies. Hedge funds are able to easily increase their portfolios’ leverage because of the nature of the compound option within an ASCOT, leaving the less lucrative bond side and its credit risk out of the equation.

What Is Arbitrage?

Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.

Arbitrage exists as a result of market inefficiencies, and it both exploits those inefficiencies and resolves them.

Understanding Arbitrage

Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader.

Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is eliminated, often in a matter of seconds.

Examples of Arbitrage

As a straightforward example of arbitrage, consider the following: The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE), while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE).

A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share.

The trader can continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or the LSE adjust their prices to wipe out the opportunity.

A More Complicated Arbitrage Example

A trickier example can be found in currencies markets using triangular arbitrage. In this case, the trader converts one currency to another, converts that second currency to a third bank, and finally converts the third currency back to the original currency.

Suppose you have $1 million and you are provided with the following exchange rates: USD/EUR = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.

With these exchange rates, there is an arbitrage opportunity:

1. Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110
2. Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171
3. Sell pounds for dollars: £591,171 × 1.6939 = $1,001,384
4. Subtract the initial investment from the final amount: $1,001,384 – $1,000,000 = $1,384

From these transactions, you would receive an arbitrage profit of $1,384 (assuming no transaction costs or taxes).

The Bottom Line

Arbitrage is a condition where you can simultaneously buy and sell the same or similar product or asset at different prices, resulting in a risk-free profit.

Economic theory states that arbitrage should not be able to occur because if markets are efficient, there would be no such opportunities to profit. However, in reality, markets can be inefficient and arbitrage can happen. When arbitrageurs identify and then correct such mispricings (by buying them low and selling them high), though, they work to move prices back in line with market efficiency. This means that any arbitrage opportunities that do occur are short-lived.

There are many different arbitrage strategies that exist, some involving complex interrelationships between different assets or securities.

Correction—April 9, 2022: A previous version of this article had miscalculated the complicated arbitrage example.

What Is the Arbitrage Pricing Theory (APT)?

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset’s returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in order to identify securities that may be temporarily mispriced.

The Formula for the Arbitrage Pricing Theory Model Is


$\begin{aligned} &\text{E(R)}_\text{i} = E(R)_z + (E(I) – E(R)_z) \times \beta_n\\ &\textbf{where:}\\ &\text{E(R)}_\text{i} = \text{Expected return on the asset}\\ &R_z = \text{Risk-free rate of return}\\ &\beta_n = \text{Sensitivity of the asset price to macroeconomic} \\ &\text{factor}\textit{ n}\\ &Ei = \text{Risk premium associated with factor}\textit{ i}\\ \end{aligned}$​E(R)i​=E(R)z​+(E(I)−E(R)z​)×βn​where:E(R)i​=Expected return on the assetRz​=Risk-free rate of returnβn​=Sensitivity of the asset price to macroeconomicfactor nEi=Risk premium associated with factor i​

The beta coefficients in the APT model are estimated by using linear regression. In general, historical securities returns are regressed on the factor to estimate its beta.

How the Arbitrage Pricing Theory Works

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the market eventually corrects and securities move back to fair value. Using APT, arbitrageurs hope to take advantage of any deviations from fair market value.

However, this is not a risk-free operation in the classic sense of arbitrage, because investors are assuming that the model is correct and making directional trades—rather than locking in risk-free profits.

Mathematical Model for the APT

While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into account one factor—market risk—while the APT formula has multiple factors. And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks.

The factors as well as how many of them are used are subjective choices, which means investors will have varying results depending on their choice. However, four or five factors will usually explain most of a security’s return. (For more on the differences between the CAPM and APT, read more about how CAPM and arbitrage pricing theory differ.)

APT factors are the systematic risk that cannot be reduced by the diversification of an investment portfolio. The macroeconomic factors that have proven most reliable as price predictors include unexpected changes in inflation, gross national product (GNP), corporate bond spreads and shifts in the yield curve. Other commonly used factors are gross domestic product (GDP), commodities prices, market indices, and exchange rates.

Example of How Arbitrage Pricing Theory Is Used

For example, the following four factors have been identified as explaining a stock’s return and its sensitivity to each factor and the risk premium associated with each factor have been calculated:

• Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
• Inflation rate: ß = 0.8, RP = 2%
• Gold prices: ß = -0.7, RP = 5%
• Standard and Poor’s 500 index return: ß = 1.3, RP = 9%
• The risk-free rate is 3%

Using the APT formula, the expected return is calculated as:

• Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%