Figure 3.5 shows the TROR transacted between the bank and the
institution. This arrangement is ﬁnancially the same as being ‘long’ the
asset in the individual cases. However a signiﬁcant advantage is now
conferred, providing the asset and the BB institution have a low default
Finally Figure 3.6 illustrates the ‘synthetic’ asset for each counter-
party. The institution has an unfunded asset as in Figure 3.4, but the
periodic ﬁnancing is ﬁve basis points cheaper. While the bank has a high-
quality credit on its books; with a higher rating than the original asset.
3.6 Securitization overview
In this section we wish to introduce an important application of credit
derivatives within the context of securitization, we are furthermore going
to use the investment management business as an example. In order to
achieve this some background is required on securitization in general.
Credit derivatives 149
BB Institution AA Bank
L 5 bps
L 30 bps
L 5 bps
Figure 3.5 The bank enters a TROR.
L 70 bps
L 30 bps
Figure 3.6 The net ﬁnancing arrangement within the TROR.
The phrase CDO is a generic expression applied to any securitization
backed by a pool of debt, usually bonds and/or loans. There are two
main categories, the cash ﬂow and the arbitrage.
The distinction is
made on the basis of collateral backing and motivation. CDO issuance
constitutes a major activity within continental Europe, indeed compara-
ble to other varieties of ABS. The term arbitrage arises because a vehicle
is established in order to beneﬁt from the funding gap which may tem-
porarily exist between the assets, typically high-yield bonds and the
liabilities, typically investment grade bonds. This has to be positive for
the viability of the vehicle.
The cash ﬂow CDO is employed by banks to remove assets from their
balance sheet. The backing consists of loans no longer proﬁtable because
of regulatory reasons. The arbitrage CDO is issued by a portfolio manager
purchasing backing in the secondary market. The resulting structure
is typically sold to institutional investors. There are many advantages
to the manager including the ability to grow assets under management.
Both CDOs have similar structures consisting of asset backing, the
creation of a bankruptcy remote vehicle (SPV) and the structuring of the
liabilities appealing to the net end investor. When the backing is mainly
bonds the CDO is referred to as a CBO, with loans the term CLO is used.
These arrangements are addressed in Section 7 within the chapter on
securitization. We also give examples of the synthetic CLO, where credit
derivatives are employed by banks wishing to seek regulatory relief. In
this section we wish to focus on the use of credit derivatives within the
investment management community.
An important development in the market has been the inception of
the investment grade CDO. This represents a new type of mandate for
the investment manager. The phraseology is misleading because the
collateral is a combination of assets including investment grade bonds
or loans. The beneﬁts are considerable, and in common with the trad-
itional arbitrage variety include the opportunity to grow assets and
consequently the fee base but further to leverage the existing expertise.
There are three alternatives: traditional ‘cash ﬂow’ CDO’s using invest-
ment grade bonds as the collateral; a fully synthetic market value CDO
which instead of having a tangible instrument backing the indenture
rely on the cash ﬂows from credit derivatives and ﬁnally a market value
hybrid consists of a combination of credit derivatives and cash bonds
150 Credit risk: from transaction to portfolio management
The arbitrage CDO is further divided into the cash ﬂow and market value categories.
The basis of distinction is that cash ﬂows are used to pay principal in the former while
receipts from sales on the collateral provide the principal repayments in the latter. This
implies that the manager can freely trade the backing in the market.