Finance and Economics Discussion Series: Understanding the Risk of Synthetic Cdos

Synthetic collateralized debt obligations or synthetic CDOs are popular vehicles for trading the credit risk of a portfolio of assets. Following a brief summary of the development of the synthetic CDO market I draw on recent innovations in modeling to present a pricing model for CDO tranches that does not require Monte Carlo simulation. I use the model to analyze the risk characteristics of the tranches of synthetic CDOs. The analysis shows that although the more junior CDO tranches -- equity and mezzanine tranches -- typically contain a small fraction of the notional amount of the CDOs reference portfolio they bear a majority of the credit risk. One implication is that credit risk disclosures relying on notional amounts are especially inadequate for firms that invest in CDOs. I show how the equity and mezzanine tranches can be viewed as leveraged exposures to the underlying credit risk of the CDOs reference portfolio. Even though mezzanine tranches are typically rated investment-grade the leverage they possess implies their risk (and expected return) can be many times that of an investment-grade corporate bond. The paper goes on to show how CDO tranches and other innovative credit products such as single-tranche CDOs and first-to-default basket swaps are sensitive to the correlation of defaults among the credits in the reference portfolio. Differences of opinion among market participants as to the correct default correlation can create trading opportunities. Finally the paper shows how the dependence of CDO tranches on default correlation can also be characterized and measured as an exposure to the business cycle or as business cycle risk. A mezzanine tranche in particular is highly sensitive to business cycle risk.