A synthetic collateralized debt obligation is a derivative instrument that allows investment in credit default swaps and other non-cash assets, with different tranches of risk, allowing investors to choose their level of risk exposure. It is not typically traded on stock exchanges and can be used by companies to hedge their positions or by speculators for high income with corresponding risk.
A synthetic collateralized debt obligation is a derivative financial instrument that allows investment in credit default swaps and other non-cash assets for the purpose of exposure to fixed income assets. While a credit default swap is a single security with very high risk, a synthetic collateralized debt obligation involves a portfolio of these securities. The instrument can be divided into tranches with different levels of risk, allowing investors to choose the degree of risk to which they are willing to expose themselves. The synthetic collateralized debt obligation therefore allows investors to gain exposure to the income stream of the underlying fixed income assets while assuming an acceptable level of risk.
A synthetic collateralized debt obligation would not normally be traded on a stock exchange. Financial intermediaries, such as investment banks and hedge funds, may be involved in the selection of reference securities, such as credit derivatives, and in the selection of counterparties. Some synthetic collateralized debt obligations have only one tranche. If there are multiple tranches, investors with lower tranches will make an initial payment; the higher tranches, which are riskier, do not always require that down payment. Equity or mezzanine tranches tend to contain a smaller part of the notional amount of the benchmark portfolio, but they are also likely to bear most of the credit risk.
Income from the underlying assets is passed on to investors in the form of periodic payments. The use of credit default swaps or other credit derivatives helps ensure that investors receive a high return, but there is also a high level of risk involved. The underlying assets related to these credit default swaps may have a high default rate. If a series of negative credit events occur, such as bankruptcy or non-payment, investors may be responsible for much higher losses than their initial investments.
The advantages of a synthetic collateralized debt obligation for investors include the flexibility for investors to assume more or less risk corresponding to different tranches. The period of time for which the synthetic collateralized debt obligation is held can be quite short, and this can be an advantage for some investors. Companies holding a large number of commercial loans can hedge their position through the use of synthetic collateralized debt obligations, while these instruments can also be used by speculators to achieve high income with corresponding risk.
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