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Synthetic CDO

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					                              Jens Weschta




SYNTHETIC CDO
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?

                          CDO


     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
  bonds
• 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
            1
                                       • 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
                   Bonds


   You
            2                          • Your write (sell) CDS contracts
                                         on the reference entities (Bonds
                                         A)
                                       • 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
                                         receive
                                    Jens Weschta




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

   Treasury
                    Yield: 2%           Bonds A          Yield: 6%
    Bonds

 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
  bonds
• CDS are quoted as spread (e.g. 400 basis points)

				
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