Structured Products and Related Credit Derivatives: A Comprehensive Guide for Investors

CHAPTER 11

Credit Derivatives and Synthetic CDOs

Brian McManus

Senior CDO Analyst

Wachovia Capital Markets, LLC

Steven Todd, Ph.D.

CDO Analyst

Wachovia Capital Markets, LLC

Dave Preston, CFA

Associate CDO Analyst

Wachovia Capital Markets, LLC

Anik Ray

Associate CDO Analyst

Wachovia Capital Markets, LLC

A credit derivative is a financial instrument whose value derives from the creditworthiness of an underlying asset, issuer or portfolio of assets. Examples include single-name credit default swaps (CDS), CDS indexes, CDS index tranches, and synthetic collateralized debt obligations (CDOs). These products are an evolving and growing presence in today's capital markets. According to the International Swaps and Derivatives Association (ISDA), as of April, 2007, the total notional amount of outstanding credit derivatives exceeded $35 trillion. Growth has been explosive; as recently as 1997 the market was tiny.

Credit derivatives are distinct from the cash assets issued in the primary markets by corporations, individuals and governments in need of cash. Like other derivatives, credit derivatives allow investors to hedge against or speculate on fairly nuanced financial outcomes. Investors can efficiently express macroviews and make relative value (convergence) trades across the capital structure, sectors, geographical regions and vintages. CDO issuers can use credit derivatives to hedge the ramp-up risk of a cash CDO or as collateral for a synthetic CDO. Investors and dealers may also ...