Chapter 27

Arbitrage CDOs are created to attempt to exploit perceived opportunities to earn superior profits through money management.

Balance sheet CDOs are created to assist a financial institution in divesting assets from its balance sheet.

Bankruptcy remote means that if the sponsoring bank or money manager goes bankrupt, the CDO trust is not affected.

In a cash flow CDO, the proceeds of the issuance and sale of securities (tranches) are used to purchase a portfolio of underlying credit-risky assets, with attention paid to matching the maturities of the assets and liabilities.

A cash-funded CDO involves the actual purchase of the portfolio of securities serving as the collateral for the trust and to be held in the trust.

A collateralized fund obligation (CFO) applies the CDO structure concept to the ownership of hedge funds as the collateral pool.

A copula approach to analyzing the credit risk of a CDO may be viewed like a simulation analysis of the effects of possible default rates on the cash flows to the CDO's tranches and the values of the CDO's tranches.

A distressed debt (CDO) uses the CDO structure to securitize and structure the risks and returns of a portfolio of distressed debt securities, in which the primary collateral component is distressed debt.

A diversity score is a numerical estimation of the extent to which a portfolio is diversified.

An external credit enhancement is a protection to tranche investors that is provided by an outside third party, such as a form of insurance against defaults in the loan portfolio.

Financial engineering risk is potential loss attributable to securitization, structuring of cash flows, option exposures, and other applications of innovative financing devices.

An internal credit enhancement is a machanism that protects tranche investors and is made or exists within the CDO structure, such as a large cash position.

In a market value CDO, the underlying portfolio is actively traded without a focus on cash flow matching of assets and liabilities.

Overcollateralization refers to the excess of assets over a given liability or group of liabilities.

The ramp-up period, is the first period in a CDO life cycle, during which the CDO trust issues securities (tranches) and uses the proceeds from the CDO note sale to acquire the initial collateral pool (the assets).

The underlying portfolio or pool of assets (and/or derivatives) held in the SPV within the CDO structure is also known as the collateral or reference portfolio.

A reserve account holds excess cash in highly rated instruments, such as U.S. Treasury securities or high-grade commercial paper, to provide security to the debt holders of the CDO trust.

The second phase in the CDO life cycle is normally called the revolving period, during which the manager of the CDO trust may actively manage the collateral pool for the CDO, potentially buying and selling securities and reinvesting the excess cash flows received from the CDO collateral pool.

Risk shifting is the process of altering the risk of an asset or a portfolio in a manner that differentially affects the risks and values of related securities and the investors who own those securities.

In a single-tranche CDO, the CDO may have multiple tranches, but the sponsor issues (sells) only one tranche from the capital structure to an outside investor.

A special purpose vehicle (SPV) is a legal entity at the heart of a CDO structure that is established to accomplish a specific transaction, such as holding the collateral portfolio.

The sponsor of the trust establishes the trust and bears the associated administrative and legal costs.

Subordination is the most common form of credit enhancement in a CDO transaction, and it flows from the structure of the CDO trust.

In a synthetic CDO, the CDO obtains risk exposure for the collateral pool through the use of a credit derivative, such as a total return swap or a CDS.

The tranche width is the percentage of the CDO's capital structure that is attributable to a particular tranche.

The weighted average rating factor (WARF), as described by Moody's Investors Service, is a numerical scale ranging from 1 (for AAA-rated credit risk) to 10,000 (for the worst credit risks) that reflects the estimated probability of default.

The weighted average spread (WAS) of a portfolio is a weighted average of the return spreads of the portfolio's securities in which the weights are based on market values.