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Synthetic CDO


									                              Jens Weschta

How to use CDS to get synthetic exposure in
the bond market
                            Jens Weschta

General 1/2
• The basic idea behind a CDO is actually very
  simple, but most people get confused by the
  terms used in the financial industry.
• CDO stands for Collateralized Debt Obligation.

                A (debt) obligation…

    CDO         which is collateralized…

                by bonds, mortgages etc.
                                   Jens Weschta

Basics: CDO, CMO, CBO?


     CMO                  CBO                     etc.

 • Depending on the underlying “asset class” we can be more
   specific and a CDO becomes a
    • Collateralized Mortgage Obligation or
    • Collateralized Bond Obligation
 • Think of a CDO as general term
                                 Jens Weschta

How to create synthetic exposure 1/4
• Suppose you want to purchase a certain bonds (Bonds A)
  because you think this bonds will appreciate over a certain
  period of time
• Unfortunately you can’t find any willing sellers of these
• What you are going to do in this case is you create a
  synthetic bond structure using
   • CDS
   • Treasury Bonds
• Here is how it works:
                             Jens Weschta

How to create synthetic exposure 2/4
                                       • You buy treasury bonds and hold
                                         them as collateral
                                       • Since you hold these bonds you
                  Treasury               receive the coupons which is the
                                         “risk free” rate

            2                          • Your write (sell) CDS contracts
                                         on the reference entities (Bonds
                                       • Since your bonds are risky they
                Credit Default           have a higher yield than treasury
                   Swaps                 bonds
                                       • The spread between the bonds
                                         and the treasury is the yield your
                                    Jens Weschta

How to create synthetic exposure 3/4
                                      Your counterparty in the
        Your position
                                        CDS (bond holder)

                    Yield: 2%           Bonds A          Yield: 6%

 Credit Default     Yield: 4%
    Swaps           (400 bp.)

 You receive        Yield: 6%

• Of course this is a simplified example but that is the basic idea
                                 Jens Weschta

How to create synthetic exposure 4/4
• Since CDS only cover credit risk the spread (yield) you
  receive is likely less
• In case you wonder is this a real-life example keep in mind
  that financial institutions are required to hedge their
  portfolios against market, credit or liquidity risk
• With regard to your position, a CDS is bilateral contract, so
  it depends of the default events specified in the contract
  whether your position is in danger or not when you are
  wrong about the price appreciation of the underlying
• CDS are quoted as spread (e.g. 400 basis points)

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