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How CDO Can Give Different Investors Different Level Of Risk

Referencing Styles : APA | Pages : 1
  • University: Dalhousie University
  • Country: CA

A CDO is a securitised debt obligations which always allow the investor to gain good number of exposures to an underlying and diversified pool of assets. However it is a very big and diversified category and hence could include many more diversified product. For example a CDO also help to collect loans and mortgages towards ensuring product security. However the CDO follows the same aspect and comes in many flavours to address the investor needs. There are many different trenches to this process which allows the investors to vary their risks and return profile which is basically known as the “waterfall cash flow structure “or they could be used in a single trench. The CDO can be of two types like cash and synthetic. The  cash CDO are the actual assets such as bond, loan and other derivative products such as default swaps ,options etc. for example default swaps are basic derivative products which are generally been used in insurance credit fields on the other hand the insurance credit roles also play an important part in the financial crisis. The structure of it is far more complex and are meant that the single and isolated pool of assets could add a single number of contracts on them by making single number of cash or money beating on them. Considering an example in this regard that synthetic CDO could give exposures to a pool of CDO which does depend on the underlying pool of assets. It also depend upon the credit quality of the insured, potentially mortgaged, loan, banks and the other pool of assets. Thus it is seen that the things get totally complicated at each and every level and hence it is literally tough for the investors to know about every exposures at each stage. Thus a single pool of mortgages worth of 1 billion GBP has been beaten due to the use of other instruments.

First place creation of CDO

On the eve of securitization of CDO, every critics on the products and the banks will be put all together in a single phrase. Hence before getting into the main stream it is important to go into some of the primary reasons to introduce the products and solve the problems initially. Firstly securitization on the mortgages will be imagined to solve a very real time problems to this aspects. Every single mortgage banks underwrote the mortgage part of in the banks balance sheet, limiting the banks further credit ability. Thus the banks mortgages off the balance sheet into a SPV and also settles of the CDO or MBS securities. Thus if  they keep on providing the service on a continuous basis , then more risks will be involved in this case and the investors will withdraw their investments. On the other hand there are some investors who could likely get restricted by the rules and regulations over the recklessness of investments they could make. They can only investment over securities with highest returns  and  hence these are rated as high  quality investors. However the banks had begun to move their mortgages into SPV by selling of their CDO. Hence they had been able to continue to serve the public by extending the mortgage value and thus by increasing the risk of the mortgages which had been taken up by the investors. However there are also a special kind of investors who had been restricted to the obligation on recklessness of investments which they could make. The individual debt instruments have the highest security value and thus they had imposed a good number of difficulties to the instruments. However for any investor these kind of instruments are need to be made and thus they need to make the most out of it. Since the loans and mortgages are not been properly rated, as by introducing the waterfall cash structure model, the most secured trenches are been highly rated and pension funds get instrument exposures.. Furthermore the CDO also allows the banks to restructure the loan packages over other asset securities .it happens because the waterfall cash flow model implies a very high range of underlying loans which is need to default before the senior tranches appeared. Similarly for the risky investment funds such as all the hedge funds or looking to invest to a higher pay-out ratio. However the banks always try to make ratio with the CDO and other number of ways. These are as follows-

  • Firstly they try to move the loans out of the banks on to the balance sheet and SPV. The banks always try out to continue over more amount if loans which equals to more fees. Then there are also CDO which are also charged to more fees by setting up SPV and CDO manager.
  • Secondly there are some arbitrage opportunities between the underlying assets and loans values towards the actual CDO trenches. However any kind of different CDO trenches when gets their ratings, then it is often seen that the company investors are often willing to pay the highest value towards the process. In genera the public companies buy CDO. Apart from this the insurance funds, pension funds, investment banks and hedge funds are the typical CDO buyers. The institutions basically buys the treasury, yields and will be hopefully going for risk diversification to outperform treasury risks. The added risk yields could bring out high return value and the investment payment is normal and when the payment feature is normal, it cans be depicted that the overall economy is also being normal to that extent. On the other hand it can be observed in revere situation by saying that when the things are slow and do not get over any actual limit, for that case if the defaults rise to the extent, the flip side is obvious and there may occur some special loss could occur for that stage. On the other hand the asset completion stage is another area where the same CDO could be bought and sold as well as future value for the asset could be taken care of.

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