Synthetic CDO


In a Synthetic CDO, I couldn’t understand why funding is not needed for senior tranch compared to junior/mezannine tranches.

Thanks for your time.

Because, motivation of synthetic CDO is to reduce ramp-up time for fund set-up. As well, Senior Tranches are looking for Premium for writing guarntee on Credit Default Swap - which is on notional amount. Only in the case of deualt beyond junior tranches, they absorb losses. As well, Senior Tranches does not get any Principal or Interest Moneny. You can think of Synthetic CDO as Cash CDO - with additional guarntee to protect against credit losses.

The reason synthetic deals are able to offer unfunded tranches is because the full notional amount is not required to establish the portfolio, and depending on how the exposure is sourced no or very little collateral may be needed. The subordinate tranches are required to be funded due to the much higher probability that they will be affected by defaults. The super-senior tranches are typically only available to highly rated entities (e.g. banks and insurance companies) since the position represents a contingent liability.