A collateralized debt obligation (CDO) that is a variation of a standard or vanilla CDO, but in which the underlying reference pool consists of derivatives, such as credit default swaps (CDS), credit options, and other credit products (e.g., credit linked notes, CLNs, etc.)
Synthetic CDOs allow markets participants to trade the credit risk of a portfolio of underlying assets, and hence such instruments/ products are classified as a credit derivative. This constitutes a vehicle, synthesized by means of securitization techniques, is used to transfer credit risk via credit derivatives, rather than through a “true sale” of receivables to an special purpose vehicle (SPV). Using credit derivatives such as credit default swaps, the originator transfers the credit risk of a pool of reference assets, or transfers the total return profile of the underlying assets through a total return swap (TRS).
Typically an SPV issues one tranche, or more, of securities which are the credit-linked notes or similar structured notes, whose payoff is linked to the performance of the reference pool. Proceeds of issuance are used to create the first-loss protection reserve (and are invested in liquid, high credit quality securities).
Synthetic CDOs may take various forms including static, dynamic, or managed. Other variations include funded synthetic CDOs, partially funded synthetic CDOs, and unfunded synthetic CDOs.
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