Synthetic CDO

Loading the player...

What is a 'Synthetic CDO'

A synthetic CDO is a form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.

All tranches will receive periodic payments based on the cash flows from the credit default swaps. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest rated tranches and working its way up.

BREAKING DOWN 'Synthetic CDO'

Synthetic CDOs are a modern advance in structured finance that can offer extremely high yields to investors. However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.

Synthetic CDOs were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without actually selling the loans and potentially harming client relationships. They have become increasingly popular because they tend to have shorter life spans than cash flow CDOs and there is no extended ramp-up period for earnings investment. Synthetic CDOs are also highly customizable between the underwriter and investors.

RELATED TERMS
  1. Collateralized Debt Obligation ...

    An investment-grade security backed by a pool of bonds, loans ...
  2. Broad Index Synthetic Trust Offering ...

    Proprietary name used by J.P. Morgan for creating collateralized ...
  3. Synthetic

    A financial instrument that is created artificially by simulating ...
  4. Synthetic Call

    An investment strategy that mimics the payoff of a call option. ...
  5. Synthetic ETF

    An investment that mimics the behavior of an exchange-traded ...
  6. Weighted Average Rating Factor ...

    A measure that is used by credit rating companies to determine ...
Related Articles
  1. Markets

    The Return of CDOs After the 2008 Financial Crisis

    Learn how the market for CDOs is coming back after the 2008 financial crisis, and understand how the market for these products has changed.
  2. Insurance

    CDOs and the Mortgage Market

    These structured products contribute to keeping borrowing rates low.
  3. Credit & Loans

    Down The Rabbit Hole: Deciphering CDOs

    Warren Buffett claims that understanding these instruments would mean reading 750,000 pages of text. Read on to learn the basics.
  4. Retirement

    Collateralized Debt Obligations: From Boon To Burden

    CDOs were to be Wall Street's boon - instead they went bust. Find out what went wrong.
  5. Investing Basics

    Understanding Structured Finance

    Structured finance refers to a complex financial transaction involving large financial institutions and companies with unique needs.
  6. Investing Basics

    A Primer On Collateralized Debt Obligation (CDOs)

    A collateralized debt obligation, or CDO, is a structured financial product backed by a pool of loans. When a retail or commercial bank approves loans such as mortgages, auto loans or credit ...
  7. Personal Finance

    Why Are Mortgage Rates Increasing?

    Learn how the secondary mortgage market and investor demand affect the cost of home ownership.
  8. Investing Basics

    What are Tranches?

    Tranches often describe specific classes of bonds within a security that hold different degrees of risks and maturities.
  9. Options & Futures

    Synthetic Options Provide Real Advantages

    Participate in options trading trading that is simpler, less expensive and easier to manage.
  10. Options & Futures

    Get Into Low-Cost Futures Trading With Synthetics

    If you can't trade commodity futures outright, these vehicles provide a less expensive alternative.
RELATED FAQS
  1. Can private investors benefit from collateralized debt obligations (CDO)?

    Learn who participates in the industry of collateralized debt obligations or CDOs. Get a general idea of how money is generated ... Read Answer >>
  2. Who bears the risk of bad debts in securitization?

    Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, ... Read Answer >>
  3. What is a Z bond in a collateralized mortgage obligation (CMO)?

    Learn about Z-bonds, which are the riskiest level of tranches in collateralized mortgage obligations, and understand how ... Read Answer >>
  4. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... Read Answer >>
  5. Is it possible to have a credit limit that's too high?

    Avoid these pitfalls when working with high credit limits, and learn how to increase your credit score by increasing your ... Read Answer >>
  6. What is the difference between a collateralized mortgage obligation (CMO) and a collateralized ...

    Both collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are similar in that investors ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center