Reference: Synthetic CDOs on page 498 of CFAI Text.
I need some clarification on the way senior sections(a.k.a tranches) are paid off in a Synthetic CDO. i realise that the Junior section invests in only high quality debt, they pay a fee for the CDS and they pay up if there is a credit event. However the book doesn’t make it clear how infact the senior sections are paid off?
Interesting for I just spent about 30 minutes trying to understand this very same thing. They do not do a good job of explaining it in the text. It appears that the senior tranche isn’t “funded” or “sold” and is just the notional amount for the synthetic CDO. This being the case my guess is the securities which make up the senior tranche stay with the owner (i.e bank or company who created the synthetic CDO) which know has the added support of the junior tranche against losses. The senior tranche just continues to get the return from the securities in the tranche whose ownership again appears to stay with the creator of the synthetic CDO. Anyone, please clarify if I’m off base here…
I also noticed that the text fell short of explaining the return to the senior section. It is my belief that the return must come from the CDS premiums. The credit derivative is the key piece in the structure, and the [typically] quarterly premium should be the source of income to the senior holders. The book made reference to the premium being available to the junior section, which I believe is also true, but only after the senior section is satisfied.
I don’t think there would be any securities, doubleW, as there would be no need to enter into the derivative contract if they already held physical.
I have the same confusion. Who receives the payments in case of default on reference rates? Is it the manager who has it all ?
I think Senior section doesn’t receive any return as no securities are purchased against the senior section (no investment made). It is just that the manager has taken an insurance policy and expects to become whole incase a credit event occurs.