Making use of the technology provided by traditional asset-backed securitizations, but with the motivation to generate arbitrage opportunities provided by perceived inefficient pricing of securities, particularly high-yield securities, there emerged in the market a new class of securitization product—arbitrage CDOs. Early examples of arbitrage CDOs are JPMorgan’s BISTRO and Citibank’s C*Star.
As noted earlier, the term “arbitrage” is loosely used. It does not have the same meaning in finance. Arbitrage in the sense used here means trying to capture via active management the spread between the return on assets and funding costs. In the early stages of the arbitrage CDO market, the collateral used was high-yield corporate debt. This asset class was selected because of what was thought to be significant arbitrage opportunities provided by the difference between implied default rates and expected default rates on high-yield corporate debt. The implied default rate is inherent in the pricing of the debt, whereas the expected default rate is based on the probability distribution of the downgrade of a particular rating. If the implied default rate is higher, there is an opportunity to make a profit.
Besides, the pooling process creates the source of profit—arbitrage CDOs are based on the underlying principle of modern portfolio theory as formulated by Markowitz: If there are n risks that are less than positively perfectly correlated and those risks are aggregated in ...