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 an American Option?

An American option, aka an American-style option, is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. It contrasts with another type of option, called the European option, that only allows execution on the day of expiration.

An American-style option allows investors to capture profit as soon as the stock price moves favorably, and to take advantage of dividend announcements as well.

How American Options Work

American options outline the timeframe when the option holder can exercise their option contract rights. These rights allow the holder to buy or sell—depending on if the option is a call or put—the underlying asset, at the set strike price on or before the predetermined expiration date. Since investors have the freedom to exercise their options at any point during the life of the contract, American-style options are more valuable than the limited European options. However, the ability to exercise early carries an added premium or cost.

The last day to exercise a weekly American option is normally on the Friday of the week in which the option contract expires. Conversely, the last day to exercise a monthly American option is normally the third Friday of the month.

The majority of exchange-traded options on single stocks are American, while options on indexes tend to be European style.

American Call and Put Options

A long call option gives the holder the right to demand delivery of the underlying security or stock on any day within the contract period. This feature includes any day leading up to and the day of expiration. As with all options, the buyer does not have an obligation to receive the shares and is not required to exercise their right. The strike price remains the same specified value throughout the contract.

If an investor purchased a call option for a company in March with an expiration date at the end of December of the same year, they would have the right to exercise the call option at any time up until its expiration date.

American put options also allow the execution at any point up to and including the expiration date. This ability gives the buyer the freedom to demand the seller takes delivery of the underlying asset whenever the price falls below the specified strike price.

One reason for the early exercise has to do with the cost of carry or the opportunity cost associated with not investing the gains from the put option. When a put is exercised, investors are paid the strike price immediately. As a result, the proceeds can be invested in another security to earn interest.

However, the drawback to exercising puts is that the investor would miss out on any dividends since exercising would sell the shares. Also, the option itself might continue to increase in value if held to expiry, and exercising early might lead to missing out on any further gains.

When to Exercise Early

In many instances, holders of American-style options do not utilize the early exercise provision, since it’s usually more cost-effective to either hold the contract until expiration or exit the position by selling the option contract outright. In other words, as a stock price rises, the value of a call option increases, as does its premium. Traders can sell an option back to the options market if the current premium is higher than the initial premium paid at the onset. The trader would earn the net difference between the two premiums minus any fees or commissions from the broker.

However, there are times when options are typically exercised early. Deep-in-the-money call options—where the asset’s price is well above the option’s strike price—will usually be exercised early. Puts can also be deep-in-the-money when the price is significantly below the strike price. In most cases, deep prices are those that are more than $10 in-the-money. With lower-priced equities, deep-in-the-money might be characterized as a $5 spread between the strike price and market price.

Early execution can also happen leading up to the date a stock goes ex-dividend—the cutoff date by which shareholders must own the stock to receive the next scheduled dividend payment. Option holders do not receive dividend payments. So, many investors will exercise their options before the ex-dividend date to capture the gains from a profitable position and get paid the dividend.

Advantages and Disadvantages of American Options

American options are helpful since investors don’t have to wait to exercise the option when the asset’s price rises above the strike price. However, American-style options carry a premium—an upfront cost—that investors pay and which must be factored into the overall profitability of the trade.

Examples of an American Option

Say an investor purchased an American-style call option for Apple Inc. (AAPL) in March with an expiration date at the end of December in the same year. The premium is $5 per option contract—one contract is 100 shares ($5 x 100 = $500)—and the strike price on the option is $100. Following the purchase, the stock price rose to $150 per share.

The investor exercises the call option on Apple before expiration buying 100 shares of Apple for $100 per share. In other words, the investor would be long 100 shares of Apple at the $100 strike price. The investor immediately sells the shares for the current market price of $150 and pockets the $50 per share profit. The investor earned $5,000 in total minus the premium of $500 for buying the option and any broker commission.

Let’s say an investor believes shares of Meta Inc. (META), formerly Facebook, will decline in the upcoming months. The investor purchases an American-style July put option in January, which expires in September of the same year. The option premium is $3 per contract (100 x $3 = $300) and the strike price is $150.

Meta’s stock price falls to $90 per share, and the investor exercises the put option and is short 100 shares of Meta at the $150 strike price. The transaction effectively has the investor buying 100 shares of Meta at the current $90 price and immediately selling those shares at the $150 strike price. However, in practice, the net difference is settled, and the investor earns a $60 profit on the option contract, which equates to $6,000 minus the premium of $300 and any broker commissions.

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