Synthetic cdos a synthetic cdo example party a wants

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Synthetic CDOs
A Synthetic CDO Example:Party A wants to bet that at least some mortgage bonds and CDOs(on these mortgage bonds) will default from among a specifiedpopulation of such securities, taking the short position.Party B (typically an investment bank) canbundle CDS related tothese securities into a synthetic CDO contract.Party C agrees to take the long position, agreeing to pay Party A ifcertain defaults or other credit events occur within that population.Party A pays Party C premiums for this protection.Party B would take a fee for arranging the deal.Synthetic CDOs
In technical terms, the synthetic CDO is a form ofcollateralized debt obligation (CDO) in which theunderlyingcredit exposures are taken on using a credit default swaprather than by having a vehicle buy assets such as bonds.Theygenerate income selling insurance against bonddefaults in the form of credit default swaps, typically on apool of 100 or more companies.Sellers of credit default swaps receive regular paymentsfrom the buyers, which are usually banks or hedge funds.Synthetic CDOs
A synthetic CDO is a portfolio of credit default swaps (CDS).It may help to understand what a CDS is first before discussingthem as a portfolio. Each CDS is a form of insurance on a bond orother obligation (the "reference security"). The CDS seller providesprotection (insurance) in the event of a default or specified "creditevent" related to the reference security.The CDS buyer pays a premium in exchange for this protection.In some cases, this represents a hedge, meaning the buyer actually owns thereference security they are insuring so losses on one or the other offset.In other cases, the bet is purely speculative, meaning a debt security notowned could be the reference security involved in the bet.Synthetic CDOs
CDS Example:Party A might own certain bonds of Company B. Concerned thatCompany B might default (i.e., fail to pay interest or principal) onits bonds, Party A can buy protection from Party C, paying apremium to Party C.In the event Company B defaults, Party C pays Party A whateveramount has been agreed between them. This arrangement is acredit default swap and represents a hedge.Party A does not have to own the bonds of Company Bto enterinto this arrangement; this would be aspeculative or "naked"CDS.Synthetic CDOs
The problem with buying a CDS is that it usuallyreferences only one security, and the credit risk to betransferred in the swap may be very, very large.In contrast, a synthetic CDO references a portfolio ofsecurities and is itself securitized into notes in varioustranches, with progressively higher levels of risk. In turn,synthetic CDOs give buyers the flexibility to take on onlyas much credit risk as they wish to assume.

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