Alternative Investments: CAIA Level I, 3rd Edition

CHAPTER 27 CDO Structuring of Credit Risk

The basic collateralized debt obligation (CDO) structure was introduced in Chapter 25. This chapter takes a close look at CDO structures with a focus on CDOs that structure credit risk.

27.1 Overview of CDO Variations

The CDO structure can be used to partition or distribute cash flows from the structure's assets and other positions to various tranches. The CDO structure has several variations, including the balance sheet CDO, the arbitrage CDO, and the market value CDO. All of these CDO structures share the feature that the entire risk of the portfolio is gathered within a special purpose vehicle (SPV) and then distributed to investors through various CDO securities, or tranches. Chapter 25 illustrated the CDO structure with stylized CDOs. In those simplified illustrations, there were only three tranches and very limited discussion of details and terminology. This chapter explores CDOs in greater detail.

27.1.1 Credit-Related Motivations for CDOs

The CDO structure was born in the late 1980s. One of the first major uses of the structure was to place a portfolio of high-yield (i.e., speculative or non-investment-grade) bonds into a CDO structure to serve as its collateral and to issue securities (tranches) against that collateral. The portfolio of non-investment-grade bonds inside the CDO offers diversification benefits, and the remaining risks can be partially reduced through credit enhancements, which are discussed later. The risks ...