CDO + CDS, Deﬁnitions & Examples.
How do they relate to Ireland today?
Securitization… is the process of packaging (illiquid)
liabilities and debt instruments, thus converting them
into liquid tradable “asset-backed securities.”
Special Purpose Investors
Payment for Proceeds
loan from the
Central Bank policies (next week)
Interest rate policies and regimes.
Funding cost changes.
Exchange Rate policies.
Models, Pricing knowledge, fast and accurate
calculation of ‘Greeks’, Hedging ability
Leads to innovations in structured credit markets
What is a structured Credit asset ?
Reasons for using structured assets
Anatomy of a structured asset
Examples -- Pricing and sensitivity
A structured asset is, at the end… an asset
incorporating a derivative strategy.
But this notion gets broader in Credit
The notion of correlated events become central
Individual Credit Risk:
Credit Exposures by tranches
of N Credit
A COLLATERALIZED DEBT OBLIGATION
(CDO) IS A STRUCTURED PRODUCT WHERE
A portfolio of securities is transferred to a SPV
SPV issues tranches of notes with different
seniority and there is also an equity stub
The CDO tranches are rated based on portfolio
credit quality, portfolio diversiﬁcation, and
Single tranche…bespoke CDO/CDO-squared
By reallocating the default probability CDO tranches
can generate returns of 15-20% from very small
But, more importantly…
…they generate assets with different
sensitivities to (default) correlation
Buy Equity tranche…
…Sell Mezzanine tranche.
The effects of default probability will cancel out.
And the correlation effect can be isolated. This can
Innovation is essential to make money
…and structured products are a major
way of doing this.
Credit default swap (CDS) market is a large and
fast-growing market that allows investors to trade
Credit default swap (CDS) is a contract between two
parties, where a protection buyer pays a premium to
the protection seller in exchange for a payment if a
credit event occurs to a reference entity. CDS are
customizable, over-the-counter products and can be
written to trigger in the event of bankruptcy, default,
failure to pay, restructuring, or any
other credit event of the reference entity.