Complicated Derivatives

Structured Finance

Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities.

There are several main types of structured finance instruments.

  • Asset-backed securities (ABS) are bonds or notes based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets.
    • Mortgage-backed securities (MBS) are asset-backed securities whose cash flows are backed by the principal and interest payments of a set of mortgage loans. it is reserved by market participants to denote the pass-through mortgage bonds (agency pass-through and nonagency pass-through).
      • RMBS: residential MBS
      • CMBS: commercial MBS
  • Collateralized debt obligations (CDOs) consolidate a group of fixed income assets such as high-yield debt or asset-backed securities into a pool, which is then divided into various tranches. , for example, ABS CDO which consist of a portfolio of different ABS bonds, and the payments to the holders of these trust certificates are derived from the cash flows of the ABS bonds.
    • Collateralized bond obligations (CBOs) are CDOs backed primarily by corporate bonds.
    • Collateralized loan obligations (CLOs) are CDOs backed primarily by leveraged bank loans.
    • Collateralized mortgage obligations (CMOs) are securitizations of mortgage-backed securities.

one of the reasons why people do create these huge synthetic structures with tranches is to be able to sell higher-rated tranches to institutional investors such as pensions, who often won't buy otherwise very risky assets.

  • Credit derivatives are contracts to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset.
  • Collateralized Fund Obligations (CFOs) are securitizations of private equity and hedge fund assets.

CDO,CDS, Synthetic CDO,CMO

  • CDO: Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is known as a tranche.
  • CDS: A credit default swap (CDS) is a swap contract in which a buyer makes a series of payments to a seller and, in exchange, receives the right to a payoff if a credit instrument goes into default or on the occurrence of a specified credit event, for example bankruptcy or restructuring. The associated instrument does not need to be associated with the buyer or the seller of this contract. It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated.
  • synthetic CDO: In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO.

Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.

CDO types based on the underlying asset:

* Collateralized loan obligations (CLOs) — CDOs backed primarily by leveraged bank loans.
* Collateralized bond obligations (CBOs) — CDOs backed primarily by leveraged fixed income securities.
* Collateralized synthetic obligations (CSOs) — CDOs backed primarily by credit derivatives.
* Structured finance CDOs (SFCDOs) — CDOs backed primarily by structured products (such as asset-backed securities and mortgage-backed securities).

Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities


A collateralized mortgage obligation (CMO) is a financial debt vehicle that was first created in June 1983 by investment banks Salomon Brothers and First Boston for Freddie Mac. (The First Boston team was lead by Dexter Senft[1]). Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it.

  • The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and receive payments according to a defined set of rules.
  • The mortgages themselves are called the collateral,
  • the bonds are called tranches (also called classes),
  • and the set of rules that dictates how money received from the collateral will be distributed is called the structure.
  • The legal entity, collateral, and structure are collectively referred to as the deal.


an asset-backed security is a type of debt security that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. Securitization makes these assets available for investment to a broader set of investors. These asset pools can be made of any type of receivable from the common, like credit card payments, auto loans, and mortgages, to esoteric cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitized assets might be highly illiquid and private in nature.

various index

  • CDX : A credit default swap index. There are currently two main families of CDS indices: CDX and iTraxx. CDX indices contain North American and Emerging Market companies and are administered by CDS Index Company (CDSIndexCo) and marketed by Markit Group Limited, and iTraxx contain companies from the rest of the world and are managed by the International Index Company (IIC).
  • ABX: An asset-backed securities index, or ABX

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