Question to be answer
Question 8
Credit default swaps (CDSs) are the most commonly and widely used type of securities known as credit derivatives designed for managing and trading of credit risk. Alternatively, a CDS can be defined as a swap contract whereby the protection buyer undertakes a series of payments to a protection seller to receive a payoff during credit event the reference bond in question e.g. downgrading and default (Goodman, 2002). CDSs are typically traded over the counter and therefore their structure often varies depending on such elements as payments, definition of default, or the underlying asset.
Structure of CDSs
CDS is an exchange between two distinct counterparties of fee exchanging a payment where a “credit default event” occurs. Particularly, one counterparty (i.e. protection buyer) makes a payment of a premium to the other party (i.e. protection seller) which in turn is obliged to pay to the buyer a specific amount in the event a default results in loses to the buyer (Goodman, 2002). In the terminology of CDSs, the protection buyer is referred to as party B while the protection seller is presented as party S.
A plain vanilla CDS structure involves three parties: the protection buyer, protection seller, and reference entity. Figure 1 below shows how a credit default swap works.
(Goodman, 2002)
Synthetic Collateralized Debt Obligations
A synthetic collateralized Debt obligation (or synthetic CDO) is a version of CDO which typically makes use of credit default swaps along with other derivatives in obtaining its investment goals (Goodman, 2002). This translates that the reference portfolio for synthetic CDOs constitutes of credit default swaps. In this regard, the synthetic CDO from investments in pools of CDSs entails integration of two types of financial technologies: i) securitization, and ii) credit derivates. With the CDO serving a vehicle, the distinct counterparties involved in the CDs contract in the asset pool typically purchase protection. In return, the CDO gets a stream of premium payments – similar to the interest payments receivable on a cash CDO – and transfer them over to the tranche investors involved in the CDP.
A synthetic CDO is usually issued in various classes or tranches, varying according to the seniority of issued notes characterized in the capital structure of the collateralized debt obligation, in which senior classes receive principal and coupon in priority to junior classes (Goodman, 2002). The main advantage of synthetic CDOs is that it offers efficient ways of gaining exposure to diversified portfolio of credits, geographical regions or industries. This credit exposure earns you periodic coupon payments. On the other hand, the synthetic CDO has risks especially for investors in senior classes whose principal and coupons may be protected from the initial credit losses accrued on the portfolio. Nonetheless, their investment may be a high risk of getting lost if the credit losses on the pension portfolio surpass the loss protection amount i.e. the combined size of the classes/tranches below it on the capital structure (Goodman, 2002).
Synthetic CDOs have three main tranches or classes: i) senior tranche, ii) mezzanine tranche, and iii) equity tranche. Generally, the mezzanine tranche and equity tranche safeguard the senior tranche from credit losses and thus earn a higher coupon as a result (Goodman, 2002).
Reference:
Goodman, L. S. (2002). Collateralized Debt Obligations: Structures and Analysis. New York: John Wiley & Sons.
