CDS, CDO, Synthetic CDO

Random Ideas

Why does credit default swap (CDS) exit?

• Transaction cost: Credit derivatives allow the credit risk component to be effectively separated from other risks (e.g., interest rate and market risk) inherent in an investment, and transferred to another party, thus making the process of gaining or reducing credit exposure more efficient.
• Ex-post bargaining power building: Goderis and Wagner "Credit Derivatives and Sovereign Debt Crises".

To model CDS, must at least have a more than 2 period time line.

Why the invention of collateralized debt obligation (CDO)?

• Game the system.
• Hide losses.
• Create liquidity: the underlying credit risky investment might be illiquid, any economic paper models liquidity?
• Transparency in credit pricing: Since credit derivatives isolate credit risk, pricing of credit derivatives is based on a pure market assessment of credit risk.

If the underlying pool of assets are CDS instead of debts, then the CDO is called the synthetic-CDO. Senior tranches in a synthetic-CDO often receive investment grade credit ratings. "Bad" underlying assets are regrouped and disguised into "good" assets, so that institutional investors with mandates can invest. This makes the investors think that they had less risk, less illiquid, less stetched-too-thin leverage, and more stability than they really did. It is like creating imaginary value out of thin air, excpet that credit enhancement is used in the process of repackaging, resulting in credit rating increase. When we abstract from the real word.

Investors => good tranches <= Intermediaries (Investment Banks and Credit Rating Agencies) <= bad assets

Synthetic-CDO weren't based on real assets, tricky to value. The impact of new government regulations, ban on over-the-counter complex financial engineerings. Correlation products. Internal and external credit enhancement.


CDO tranche payoff depends on the number of defaults.