One example of financial engineering is the ASCOT structure the name is an acronym for Asset Swapped Convertible Options Trade.

The structure involves a series of trades:

• Firm A buys a convertible bond in the market, in this example for $1,000
• Firm A enters in to an asset swap with Firm B in which Firm A agrees to sell the convertible bond to Firm B at, for example $900, and enters into a swap in which Firm A receives fixed payments equivalent to the convertible bond coupons and pays a floating rate to Firm B.
• Firm A and Firm B agree that Firm A has the right to buy the convertible bond back from Firm B at firm As option in the future.
• Firm B enters into a credit default swap agreement with a third party, Firm C, paying a fixed premium, and names the issuer of the convertible bond as the referenced entity.

Required:

a) Draw a flow diagram of the trades involved here.

b) What is firm As motivation here?

c) What is firm Bs motivation here?

d) What is firm Cs motivation here?

e) Why does firm A sell the convertible bond to firm B at a lower price than they paid for it in the market?

f) From As point of view, what risks are they exposed to? What risks have they hedged?

g) From Bs point of view, what risks are they exposed to? What risks have they hedged?

h) From Cs point of view, what risks are they exposed to? What risks have they hedged?

i) Under what circumstances would firm A exercise the right to buy the convertible bonds back from firm B?