Introduction to Securitization

INDEX TRADES AND INDEX TRACKING CDOs

If we think of an arbitrage synthetic CDO, it is a pool of synthetic exposure in a broad-based list of corporates or structured finance products. An investor investing in, say, a BBB tranche of this CDO is making a synthetic investment in the pool of assets of the CDO. Because the investor is taking a position in a subordinated tranche in the pool, the investor is effectively making a leveraged synthetic investment in the pool of entities comprised in the pool. The investor is therefore taking a view on the credit quality of the underlying names.

As synthetic CDOs grew, there emerged in the marketplace a need to offer an instrument whereby investors may express a view on a generalized pool of corporate names. For example, if someone wanted to express a view on the quality of Corporate America, this would not be possible in a single-tranche CDO (referred to as a bespoke CDO). Hence, structurers developed indexes. An index is a broad, standard list of names from a particular geography or particular sector—the movements in the index would represent movement in the whole spectrum of the geographical region or the sector in question.

There are various such indexes trading currently. CDX.NA is an index representing North American names. iTraxx is an index of corporate and noncorporate names from Europe and Asia. Each of these indices have subsets, such as index of investment-grade names (CDX. NA.IG), or index of below investment-grade names (CDX.NA.HY). ...