CAIA Level I: An Introduction to Core Topics in Alternative Investments, 2nd Edition

CHAPTER 25

Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are a form of asset-backed security (ABS). The basic structure of CDOs was introduced in Chapter 23. This chapter provides additional information, including the economic motivations for CDOs, and discusses major distinctions between types of CDOs.

25.1 INTRODUCTION TO COLLATERALIZED DEBT OBLIGATIONS

The CDO structure has several variations, including the arbitrage CDO, balance sheet CDO, and market value CDO. The CDO structure can be used to partition or distribute the cash flows from the structure's assets and other positions to various tranches. This structuring of cash flows generates different levels of risk and return in the various tranches. In the case of some CDO structures, there is little or no credit risk in the collateral portfolio, and therefore the primary function of the structure is to generate tranches that differ based on the timing of the cash flows. In these structures, senior-most tranches receive cash flows first and are viewed as short-term and low risk. Junior tranches have longer terms and greater uncertainty with regard to when the principal will be repaid. The CDOs of insured and government-agency-backed mortgages, known as collateralized mortgage obligations, are popular applications of structuring that focuses on the timing of cash flows. The emphasis in this chapter is on structuring the credit risk of fixed-income assets.

All of these CDO structures share the feature ...