Cash vs Synthetic Structures
• Synthetic CDO structures involve the use of
credit derivatives.
Arbitrage Transactions
Create an arbitrage CDO is whether a structure can offer a
competitive return for the subordinate/equity tranche as below:
Tranche
Par Value
Coupon Value
Coupon Rate
Senior
$80,000,000
Floating
LIBOR+70 basis
points
Mezzanine
$10,000,000
Fixed
Treasury rate +
200 basis point
Subordinate/Equity $10,000,000
Assumptions
• The collateral of the CDO:
• bonds that all mature in 10 years
• The coupon rate for every bond is a fixed rate
• The fixed rate at the time of purchase of cash bond is the 10 year
treasury plus 400 basis points
• To finance the senior tranche,
• collateral manager enters into an interest-rate swap with another
party with a notional principal of $80 million in which it agrees to do
the following:
• Pay a fixed rate each year equal to the 10-year Treasury rate plus 100
basis points
• Receive LIBOR
Cash flows
• Assuming the 10-year rate at the time the CDO is issued is
7%.
• Interest received from collatoral:
• Interest to senior tranche:
• Interest to mezzanine tranche:
• Interest to swap counterpart:
• Interest received from swap counter part
• As a result,
• Total interest received:
• Total interest paid:
• Net interest
Synthetic CDOs
• In a synthetic CDO, the collateral absorbs the
economic risk associated with specified assets
but does not have legal ownership of those
assets
• Requires the use of CDS