I find this to be one of the more unintuive topics in the course. Can anyone epxplain what is really going on in a Synethic CDO and how it compares to Cash Flow CDO? Also, Schweser pg 159 book 5 says that the senior note holders recieve a small premium for the CDS and then two sentences later says “the bottom line is that the junior bondholders recieve inceme from the high quality debt securities as well as the insurance premium on the CDS.” So which is true, senior or junior–or both? Thank you.
the show NY Wrote: ------------------------------------------------------- > I find this to be one of the more unintuive topics > in the course. Count me in too. This is ridiculous. I have read research papers and presentations on the internet but still no luck for me. Hope someone comes out and explains in plain simple english, what this exactly means. Good luck to the laywers/judges tying to investigate the failure of AIG and other CDS counterparties. They will need a lot of white board space to understand what a freaking balance sheet CDO and synthetic arbitrage CDO/ CLO does…
My understanding , there is really no party paying the senior part of the synthetic CDO. Say the Junior pay 10%, if the bond fails, then Junior trench got to pay the whole amount 100%, as compensation, they got a little CDS premium. in cash CDO, the issuer has to find someone who are willing to invest 100%, that is tougher than finding some risky investor who can only investor 10% but willing to take 100% exposure.
no party paying the senior part? the senior tranche does get paid interest on collateral though…as does the mezannine…then leftover, if any, goes to equity tranche
Only the junior tranche is funded in a synthetic CDO. In Schweser’s example, I believe they relate a situation where the junior tranche is funded $10 million out of a total of $100 million exposure. The other $90 million is from selling a CDS. Remember that in CDOs the senior tranche tends to be a floating rate and the mezzanine and junior trances are fixed rates.
“Remember that in CDOs the senior tranche tends to be a floating rate and the mezzanine and junior trances are fixed rates.” Another example of the CFA curriculum deviating from the real world - I worked in CDOs for a few years and never, ever, ever saw a fixed rate tranche. Ever. But I’ve got no problem suspending reality for six hours on a beautifful Saturday in June.
rellison, can you please explain what you mean by “only the junior tranche is funded.” clearly, the senior tranche gets interst payments. so if the seniors dont have to pay anything how can they get a return?
The AAA noteholder was (99.99%) always a large financial institution with a strong credit rating, so they would issue ("write) a credit default swap for their tranche - the $90MM senior piece. That way, the “spread” that they’re paid from the deal is actually a premium on that CDS (although . However, Citibank/GS/JPM etc. would not have to post collateral, because they (were) all rated BB+ and their “word was their bond”. Basically, the banks figured that there was no way that they’d ever take a principal hit above 10%, which means that they were basically collecting “free money” to insure the AAA piece. “Oops”.
Guys, Try this… This should definitely be of some help. http://www.youtube.com/watch?v=0Q7ji-vPlP4