CDO is the acronym used for a collateralized debt obligation, which is a synthetic investment product made up of a range of income-generating assets that is divided into tranches with different risk profiles and repayment priorities.
Breaking Down CDO
While CDOs may seem complex at first glance, they are actually reasonably simple to understand, even if advanced mathematics are required to create and value them.
The term ‘debt obligation’ just means that the financial instrument is formatted as credit, as opposed to equity. Therefore, the general structure of a credit instrument applies to how a CDO is sold, owned, traded and how the contracted obligations of the CDO are met.
In this sense, a CDO is no different from any other bond, where the holder of the CDO is legally entitled to the contracted repayment terms outlined in the CDO, with a structure in place in the event of defaults or missed payments.
‘Collateralized’ describes the fact that the debt obligation is backed by income generating assets, such as bonds, mortgages and loans. This means that in the event of a default, the owner of the CDO has some recourse to compensation through the liquidation of the underlying assets, which act as a form of collateral for the CDO.
Finally there is the matter of the ‘tranches’. The combination of a range of assets into the CDO means that there is a variety of ways that the risk of the entire entity can be apportioned.
The CDO’s risk could be all bundled together as the total of the correlated risks of the underlying assets, or this total risk could be split up into different levels, or tranches, and then sold separately based on investor appetite.
Therefore, investors willing to bear more risk would take on any defaults of underlying assets first, but they would pay a lower price for their access to the income generated by the underlying assets.
Trading and CDOs
CDOs and derivatives tied to them are generally reserved for large institutional investors that are looking for ways to balance timed income flows and risk exposure, which means that day traders will not have direct access to trading CDOs or their derivatives.
One avenue for profiting as a day trader from CDOs is to exploit the difficulty in the valuation that arises during periods of low liquidity. When liquidity is low, it becomes harder for accurate price discovery to take place due to low trading volumes.
This means that even simple assets become more difficult to value, whereas complex assets composed of a range of underlying assets, such as a CDO, can be next to impossible to generate an accurate valuation for.
Therefore, during times of low market liquidity, institutions with a large exposure to CDOs may face difficulty in securing funding due to precipitous drops in the value of their assets, which makes an excellent shorting opportunity for day traders.
Despite the role that CDOs played in the 2008 financial crisis, they are still very popular to this day. However, the underlying problems involved in valuing complex instruments during periods of low liquidity have not changed, meaning that they may once again be a catalyst or channel for contagion for a future financial crisis.