Can someone explain to me in layman the role of the credit default swap arrangement for Synthetic CDO’s. I clearly understand the role of the interest rate swap for the Arb. driven CDO but not understanding the credit default swap for Synthetic. I was doing an EOC in the fixed income section yesterday and I am sure the question had said that the Z- Tranche is not affected by prepayment risk. I thought that the Z- Tranche was most susceptgible to extension risk. Can someone give a quick overview
If you sell £100m worth of CDS you will receive a premium, that premium will be used in part to pay the coupon on the CDO. Having a Z tranche doesn’t affect prepayment risk, because it doesn’t absorb any prepayments over or under the expected rate (like a support tranche), but it has significant prepayment risk because it’s only paid when everything else is paid
kurupt1 Wrote: ------------------------------------------------------- > If you sell £100m worth of CDS you will receive a > premium, that premium will be used in part to pay > the coupon on the CDO. > > Having a Z tranche doesn’t affect prepayment risk, > because it doesn’t absorb any prepayments over or > under the expected rate (like a support tranche), > but it has significant prepayment risk because > it’s only paid when everything else is paid I’m confused by your second statement. You say the Z tranche has significant prepayment risk because it’s only paid when everything else is paid. What does this have to do with prepayment risk?
bpdulog maybe you’re right not sure… i would think there was significant extension risk, but the investor would receive a higher return (as interest accrues) given extra time taken to pay off senior tranches
Post the Q. I can only assume that it probably mentioned the Subordinate class bonds which guard against credit risk and not prepayment risk. Tranching IS used for prepayment risk and a Z-Tranche would be most susceptable to this.
As i recall, the question asked whether having a z tranche affects the prepayment risk on a more senior tranche the answer to which is no
Senior tranche most exposed to contraction risk, as they want scheduled payments according to their liability time frame, Z tranche exposed most to extension risk as they are the accrual tranche and therefore the farther out the payments stretch, the lower the value of the income, TVM. I think this is it.
Z-Tranche is most exposed to extension risk. They may never get paid out if rates drop too fast and lose whole investment like Orange County CA. Their is no more interest to pay and the senior has to get paid out first. The Z-Tranche is least exposed to contraction, because senior gets paid out first. With the CDS on the synthetic. The main point to take away is the whole purpose of the Synthetic CDO is for the manager to be able to better analyze the loan or bonds than the bank or dealer. Then they sell a CDS against a certain amount of defaults in the portfolio and hope to god the CDS never has a credit event. They can collect the premium and pay out tranches with money. If there are more credit events than the sold CDS allows, the senior, junior and mezz start to lose money.