Introduction to Securitization

TYPES OF CDOs

CDOs may be classified into various types from different perspectives as shown in Table 11.1. In this section, we describe each type briefly. A detailed discussion of CDO types, along with the structure of each, is provided in the next chapter.

Cash and Synthetic CDOs

CDOs may acquire assets in cash or synthetically. The cash asset CDO acquires assets in a traditional manner—raising the funding required equal to the size of the CDO and investing the same in acquiring the assets. The assets are acquired either from one originator (as for balance sheet CDOs) or from the market (as for arbitrage CDOs).

TABLE 11.1 Classification of CDOs

For synthetic CDOs, the assets are acquired synthetically, that is, by signing up credit derivative deals selling protection against the assets. The process of creating synthetic assets can be described briefly as follows: In a credit derivative, a protection seller agrees to make a certain payment, called a protection payment, when a particular entity, called a reference entity, undergoes a specific credit event. As compensation for selling this protection, the protection seller receives a periodic payment, called a premium, which is comparable to the spread earned in actual funding transactions. Since the protection seller thus acquires credit risk on the reference entity, and earns a premium representative of credit spreads, ...