Question regarding Synthetic CDO

CFA Level II
#1

Hi all,

I have just covered the asset-backed securities reading and get some confusions on Synthetic CDO. Please give some help.

  1. What is the role of senior section? There’s no funding obtained from using debt obligations to senior section as I know.

  2. Why does the notional amount in credit-default swap have to be equal to the amount of senior section?

  3. One of the economic advantages (arbitrage-driven) in using CDO is that “there are opportunities to be able to effectively buy the assetsincluded in the reference assets via credit-default swap than buy the asset directly” => Who’s actually buying these asset?

  4. I don’t understand how banks can use CDO to eliminate loan instruments from their balance sheet by using credit-default swap because proceeds from issuing debt obligations to junior note holders are used to buy high-quality debts, not the banks’ debts as in other structured financial products. Is the reference asset what the bank is holding?

It seems like I’m lost when getting into this section. Please help me. Thank you very much.

#2

Hi all, I’m still waiting for help. I really need some. Thank you.

#3

[quote=“vanphapdang”]

Hi all,

I have just covered the asset-backed securities reading and get some confusions on Synthetic CDO. Please give some help.

  1. What is the role of senior section? There’s no funding obtained from using debt obligations to senior section as I know.

Yes, the senior section does not provide any funds. It is non-funded. However, it bears the risk if the credit event is of an intensity greater than 10%

  1. Why does the notional amount in credit-default swap have to be equal to the amount of senior section?

Because that is the amount which requires insurance. Please remember that the senior tranch does not pay anything.

  1. I don’t understand how banks can use CDO to eliminate loan instruments from their balance sheet by using credit-default swap because proceeds from issuing debt obligations to junior note holders are used to buy high-quality debts, not the banks’ debts as in other structured financial products. Is the reference asset what the bank is holding?

Banks eliminate credit risk through credit default swaps while still holding assets on the balance sheet.

Synthetic CDOs’ : Remove credit risk without asset sales

Normal CDO’s : Removes Credit Risk with asset sales.

Hope that helps. Let me know if you want any further clarification.