Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with value and payments derived from a portfolio of fixed-income underlying assets.

Collateralized loan obligations (CLOs) are CDOs backed primarily by leveraged bank loans. Collateralized bond obligations (CBOs) are CDOs backed primarily by leveraged fixed-income securities.

CDOs are assigned different risk classes, or tranches.

*A senior tranche:*between 70% and 80% of the deal and receives a floating-rate payment*Subordinated or mezzanine tranches:*receive a fixed coupon rate*Equity tranche:*provides equity protection to other tranches. It receives any remaining interest that is received from the collateral but not paid to the senior and mezzanine tranches.

Problem: The majority of investors are paid a floating rate, whereas the underlying pool bonds pay a fixed rate. If rates rise, the

Solution: The manager must protect against rising rates. Entering a swap as the fixed payer (variable receiver) solves the problem, as this position provides positive cash flow when interest rates rise.

Consider the following CDO transaction:

- The CDO is a $100 million structure.
- The collateral consists of bonds that all mature in five years. The coupon rate of these bonds is the five-year T-bond rate plus 500 basis points.
- The senior tranche is 75% of the deal. It pays a floating rate of LIBOR + 50 basis points.
- There is only one mezzanine tranche of $10 million with a coupon rate of the five-year T-bond rate + 400 basis points.
- The asset manager enters into a swap in which it pays a fixed rate equal to the five-year T-bond rate + 150 basis points and receives LIBOR. The notional amount of the swap is $75 million.
- Assume that there is no default or asset management fee. All payments are made annually each year for simplicity.

Analysis

The equity tranche is $100 - $100 x 0.75 - 10 = $15 million.

Each year:

- The collateral will pay interest of $100 x (T-rate + 5%) million to the CDO.
- The CDO pays $75 x (T-rate + 1.5%) to the counterparty of the swap and receives $75 x LIBOR.
- Interest to senior tranche: $75 x (LIBOR + 0.5%)
- Interest to mezzanine tranche: $10 x (T-rate + 4%)

Netting the interest payments paid and received:

$100 x (T-rate + 5%) - $75 x (T-rate + 1.5%) + $75 x LIBOR - $75 x (LIBOR + 0.5%) - $10 x (T-rate + 4%) = ($15 x T-rate + $3.1) million

If the five-year T-rate at the time the CDO is issued is 5%, the amount available each year for the equity tranche is $15 x 0.05 + 3.1 = $3.85 million.

- Arbitrage transactions attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority of CDOs are arbitrage-motivated.
- Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions' desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload credit risk in order to reduce its balance sheet's credit risk.

JimM: Oh what a tangled web we weave,When first we practice to deceive! |

chris54321: Nice one Jimmers |

ynaghibi: So the sr class of the synthetic cdo gets a periodic payment that is a part of the swap premium even though the swap transaction was with the jr class? Or does the sr class get paid some predetermined lesser rate that is pegged to the reference asset in return for taking on the lesser amount of credit risk? I think I get everything except that. |

sahilb7: Can someone explain from where we get the (15 x T-Rate+$3.1) in this example? I think I am missing something. |

sahilb7: Never mind. Problem solved. Thanks. |

niuniucow: @sahilb 7 , yeah , problem solved. took me a little time to get it too. |

maryprz14: I believe US financial system is capable of doing any sorts of complicated ...they collateralize literally everything and they invest on it; collateralized mortgages, car loans, Credit Card debts, student loans, my debt to my grandma since my high school time and... It's crazy |

guest: CFAi book on Pg. 511 has an example (EX-12) where it says that the risk due to potential mismatch between the collateral making fixed rate payments and bond classes making floating rate payments is characteristic of ABS and not CDOs. Confused between the risk differences of ABS, arbitrage CDOs, and regular CDOs. |