Synthetic CDO

CFA Level II Fixed Income
#1

Hi everyone,

I’m having problems understanding how synthetic CDOs actually work. Need big helps from you guys :smiley:

#2

What exactly do you struggle with? CDO, swaps, …cash cdo’s…?

Good luck buddy; there are a lot of “synthetic cdo’s” within the level II curriculum.

#3

Are you studying L2 already???

#4

I am bro :smiley:

#5

Good for you. Be forewarned, though … as I also started “early” (late-July of 2013 for the 2014 exam), and found myself burnt out by April. Don’t start too early!

#6

A real CDO has debts (the “D” in “CDO”) that provide the cash flows: mortgages, car loans, student loans, credit card cebt, whatever.

A synthetic CDO has derivatives (e.g., CDSs) that provide the cash flows, instead of actual debts.

#7

synthetic CDO:

  1. the concept of taking the risk but not the physical control of the debts.

  2. what part of it is actually funded ?

  3. what is the cash flow available to the junior/subordinate holders ?

  4. why is it more attractive than traditional CDO ?

#8

This is what I can imagine from the textbook:

Assuming a partially funded synthetic CDO:

An SPV is established on a notional amount of, say $100 million, but only $10 is actually raised from subordinate tranch, the senior trach does not contribute any fund to the SPV. This $10 million is then used to purchase high-quality securities.

Also, the SPV will enter into a short position in a CDS arrangement with the bank, in return receives periodic CDS fees.

CDS fees and income/principal streams from those high-quality securities will be used to pay off the tranches and how they are paid depends on the intitial specification of the SPV.

Since any losses (in the event of default of those loans) will be absorbed by the subordinate tranch, the senior tranch will only incur loss if the amount of defaulted loans exceed $10 million.

So the bank effectively transfer the credit risk of the loans to the SPV (by entering into a CDS), thus to the holders of different tranches, without selling the actual assets (loans).

Basically a synthetic CDO is a CDS within a structured fixed income security?

Am I correct?

#9

Mostly correct but -

SPV will enter into a long CDS position (receives premium and pays losses). Long CDS means selling protection.

Avoid using the term CDS Fees - ideally use the term CDS premium / coupon

The diagram on wikipedia is quite a good and accurate explanation http://en.wikipedia.org/wiki/Synthetic_CDO