Just out of curiosity, I am wondering the benefits to a bank in creating a CDO structure vs buying a CDS. CFAI notes the bank benefits by eliminating credit risk and/or taking assets of the BS, but isn’t buying the CDS almost an identical position. thanks for your opinion.
I can think of two reasons: -Sometimes a bank just wants to get rid of certain loans (when they don’t want the hassle of servicing those loans, for example). -When you buy a CDS, you are still exposed to default risk of the CDS counterparty. Taking assets of the BS usually completely eliminates credit risk.
as a bank when you create a synthetic CDO structure - what are you risk and rewards?
If you can sucessfully market it , it can take a bunch of risky debt cleanly off of your BS and take the credit risk mostly out of the picture. Risks are that it might come at a cost , but probably much less than the option is actually worth in terms of risk mitigation
janakisri Wrote: ------------------------------------------------------- > If you can sucessfully market it , it can take a > bunch of risky debt cleanly off of your BS and > take the credit risk mostly out of the picture. > > Risks are that it might come at a cost , but > probably much less than the option is actually > worth in terms of risk mitigation +1 Just to elaborate further as I understand it. Say, a bank has 10m of risky loans it has distributed. These are assets to the bank, but there is a credit risk involved with this 10m asset. Which is, the counterparty may not fulfil its obligation in paying interest or the principal. So, as a bank, I structure a synthetic CDO. I do 2 things: 1. I raise cash from the junior section of this structure and buy treasury securities. 2. Also, I sell a credit default swap on a bigger notional amount (say 100m, 90 + 10). Junior section will receive most of the premium coming from writing this swap. In affect, this structure has taken over the credit risk of 10m of my original assets + 90m of market assets. And probably, the premium paid to CDO holders is for 90m only. So I have transferred my credit risk on 10m assets to CDO holders, at the cost of administering and managing this CDO.
I think the bank will be BUYING the CDS part , and the junior section will be Selling CDS ( ie. selling the default risk coverage and collecting the premium). Bank buys coverage from juniors. The CDS is a derivative instrument , not treated the same in balance sheet as the original debt .