the credit default swap—who issues the cds, and who recieves the premiums
Could you refine that question a bit, please? A synthetic CDO is comprised of CDS…
the issuer is the seller and receives the premium. The person paying is buying insurance.
what i meant was: a componenet and source of income for a synethic cdo is the cds. what role do the junior tranche and senior tranche play here. my understanding was that both the senior tranche and the junior tranche recieve the premium? is that right
THE component and THE source of income for a synthetic CDO is the premiums from the CDS that the CDO has written on cash bonds. What exactly do you mean by “what role do the” etc., etc,?
OK so let’s start with a cash CDO - I have a basket of securities that yield me 8% and I issue short term paper that costs me 7.85%. Basically a basis trade structure. But show, that is too simple, why not for the 15bps your are going to earn, just create this synthetically. So you ask how, you go to the conference room with Swaption Gamma and CPK and they tell you about their new structure, selling 100 CDS’s and receiving that same 15bps. But since you created the whole thing synthetically why not make it more fun. Let’s turn it into a capital structure. The first tranche will be equity, the second mezz, the third junior subordinated notes, and the last the SENIOR TRANCHE. As companies start defaulting, and because swaptiongamma was in fact so not gamma neutral (the killer of all option market makers) the equity piece absorbs the first loss, and it moves up the chain as defaults rise and you have to pay out on your CDO. You say, wow 15bps for all that risk, that is awesome, especially if I can sell $1trillions worth and get $150m bonus. Seriously, they both receive different amounts of premium consumerate to their risk and the junior tranches payout first in case of default.
• The collateral in the Synthetic CDO (SPV ) is a portfolio of credit default swaps instead of actual debt or loans. • The premiums on the CDS provide cash flow to the SPV. The SPV invests these cash flows in eligible investments which then yield interest. If defaults occur, then pay out of fees and interest • The SPV issues three or more tranches of debt securities rated from triple A on down the ratings ladder • The junior note holders are getting payments from two sources: (1) the income from the high quality securities purchased with the funds from the issuance of the junior debt obligations and (2) the premiums from the CDS paid by the asset manager to the SPV. Effectively, the junior note holders are receiving the return on a portfolio of high-quality assets subsidized by the CDS premiums. However, this ignores the obligation of the junior note holders with respect to the CDS. If there is a credit event that requires the junior note holders to make a payment to the protection buyer, then this reduces the return to the junior note holders. As noted earlier, the effect on a particular tranche of the junior section depends on its priority. That is, the subordinate/equity tranche is affected first before the most senior tranche and the other tranches superior to the subordinate/equity tranche is affected. • Ability to use CDS to increase leverage made this process go out of hand
Jainan, In effect though the only thing you have to show is a security for the face value of the premium you took in plus any accrued interest, did anyone that sold these structures calculate how many default events would wipe out the structure? I mean basically a synthetic CDO is a synthetic insurance company.
I don’’ think CFA expects you to know how to model defaults thats more of FRM material
lots of writing to read i’ll try to be quick 1) CDS is like car insurance if you buy protection you pay premium and get coverage, so with if you issue CDS you get the premium and provide protection 2) How does selling CDS creates CDO? If the underlying asset defaults you have to pay cuz you provide insurance so in a sense you assume risk of the asset that would underlie a CDO. Now you are getting premiums from selling CDS which represent credit risk of CDO, and then you get risk free return from treasuries, so here is you get CDO return ( risk free plus credit spread). Hope this helps.
“The premiums on the CDS provide cash flow to the SPV. The SPV invests these cash flows in eligible investments which then yield interest. If defaults occur, then pay out of fees and interest • The SPV issues three or more tranches of debt securities rated from triple A on down the ratings ladder • The junior note holders are getting payments from two sources: (1) the income from the high quality securities purchased with the funds from the issuance of the junior debt obligations and (2) the premiums from the CDS paid by the asset manager to the SPV. Effectively, the junior note holders are receiving the return on a portfolio of high-quality assets subsidized by the CDS premiums.” Nah, dude.
skillionaire Wrote: ------------------------------------------------------- > “The premiums on the CDS provide cash flow to the > SPV. The SPV invests these cash flows in eligible > investments which then yield interest. If defaults > occur, then pay out of fees and interest > • The SPV issues three or more tranches of debt > securities rated from triple A on down the ratings > ladder > • The junior note holders are getting payments > from two sources: (1) the income from the high > quality securities purchased with the funds from > the issuance of the junior debt obligations and > (2) the premiums from the CDS paid by the asset > manager to the SPV. Effectively, the junior note > holders are receiving the return on a portfolio of > high-quality assets subsidized by the CDS > premiums.” > > Nah, dude. Lol, I like how you casually dismiss his paragraph long explanation.
“So you ask how, you go to the conference room with Swaption Gamma and CPK and they tell you about their new structure, selling 100 CDS’s and receiving that same 15bps.” I used to structure CDOs, so I humbly submit that you may want me in that conference room as well. "• The premiums on the CDS provide cash flow to the SPV. The SPV invests these cash flows in eligible investments which then yield interest. If defaults occur, then pay out of fees and interest " No, the premiums are the sole source of payments to both junior and senior tranches. “• The junior note holders are getting payments from two sources: (1) the income from the high quality securities purchased with the funds from the issuance of the junior debt obligations and (2) the premiums from the CDS paid by the asset manager to the SPV. Effectively, the junior note holders are receiving the return on a portfolio of high-quality assets subsidized by the CDS premiums.” See answer above. I just got some nice head from Ms. Skillionaire, so I’m in a pretty good mood and am trying to be as nice as about this as possible, but that’s just wrong. Also, shocked that no one mentioned that the senior portion is unfunded - that’s one of the easy questions that could be asked.
hahaha nice one
I did not make this up. I got this from Fabozzi book so blame him if you feel if any thing is wrong. Usually junior tranches have higher return so higher risk.
Not debating with you on Fabozzi (both a smart and nice man), just differentiating between real life and what people need to know for Saturday. Junior tranches do have higher return, so their risk is also higher, that’s correct.
no i just liked the sarcasm part the cfa part makes sense.
The way I see Synthetic CDO is that it’s a scam.
Skillionaire, I think what Jainan was describing is what we like to call a Hybrid CDO. Which combines some physical assets with CDSs. Since you used to create CDOs and you blew up the bank, we fired you so you were not on the conference room. If it’s any concillation though, we gave you a $28m bonus the year before we fired you. Do you just fund the junior pieces since they are more susceptible to credit events. And you can see how selling hedge funds senior tranches as 40x leverage wiped many out when everything crapped out.
In lay terms, why would someone prefer a Synthetic CDO over a Cash CDO? Is it because Senior debt holders get more protection, leaving Junior tranches take it up the _ _ _