hey guys, this is page 268-269 in the CFA book 5; they talk about the synthetic CDO’s and then they give an example with $500 million of notional amount. I just did not get how its done?? I understand that there is a senior and a junior tranche with $450 million for the senior and $50 million for the junior tranche. Then the portfolio manager buys securities with the $50 million isued by the SPV. I understand this part. Then they talk about the credit default swaps and how the manager is the buyer of the swaps with $450 million notional amount and the SPV is the seller of the swaps. I dont understand this part and where the money that the portfolio manager is buying this proctection comes from? I guess I just dint get it!!! Can someone who gets it explain it to me?
I think this was discussed b/f so you may want to search but, a synthetic CDO is made up of assets that are reference entities (or synthetic assets, CDS, etc). This is different compared to cash assets. Using Citigroup Bonds as an example, a regular cash CDO will have these bonds as one of the many assets they carry. A CDS is a quasi-insurance payment. One party pays a fee in return for protection in case of default. So you can have a CDS on Citi. Party A pays Party B a fee and in return they will receive a payment for Party B in case Citi defaults (or some agreed upon credit event…a la downgrade etc occurs). A synthetic CDO is a CDO whose assets is normally long a portfolio of CDS securities.