Credit Derivatives and Structured Credit: A Guide for Investors

4

Collateralized Debt Obligations

Collateralized debt obligations, which we shall refer to hereafter by their acronym CDO, cover a large range of products and currently represent one of the most dynamic segments in the credit derivatives market.

One common denominator of these transactions was, until recently, the application of securitization techniques to assets sourced in the financial markets, such as bonds (collateralized bond obligations or CBOs), or from corporate or financial institutions' balance sheets, such as bank loans (collateralized loan obligations or CLOs). In this area, however, the development of credit derivatives has led to the emergence of a new type of products, synthetic CDOs,¹ the recent variations on which are more like the exotic credit derivatives described in the previous chapter than traditional securitization transactions.

The relative position of CDOs among securitization products is shown in Figure 4.1.

Although traditionally, the majority of CDO underlying assets were unitary credit risks (e.g. corporates), the range of products covered by CDOs has recently increased considerably, and now covers other securitization issues (CDOs of ABSs),² or even other CDOs (CDOs of CDOs or CDO-squared).

Several types of CDO can be identified depending on:

• The objective of the transaction (arbitrage or balance sheet management-driven).
• The risk transfer mechanism: acquisition of securities (cash CDOs) or use of derivatives (synthetic CDOs).
• The management strategy ...