CDO
Glossary

ABCP

(Asset-Backed Commercial Paper) - interest-bearing short-term notes backed by assets

Advance Rate

- in a market value CDO, a weighting applied to the market value of the collateral to reflect the liquidity of each asset. An advance rate of 100% would be applied to the most liquid asset. An advance rate of 0% would mean the asset receives no credit in calculating the CDO's OC test. The term "discount rate" is also used to refer to the same concept

Attachment Point

- the minimum level of losses in a portfolio to which a tranche is exposed, usually expressed as a percentage of the total notional size of the portfolio

Asset Correlation

- the degree to which asset values (and, therefore, according to the Merton model, default probabilities) move in tandem. Equity prices are widely taken as a proxy for asset correlation

Basket

- see nth-to-default basket

Call Option

- an option contract giving the the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within or at a specified time. For credit default swaps options, a call can be a call on risk (receiver) or on protection (payer)

Cash CDO

- a CDO backed by a portfolio of cash assets such as bonds

Cash Settlement

- a payout following a credit event in which the protection seller pays the protection buyer an amount equivalent to the par value of the deliverable obligation less the recovery rate. This amount is determined by the calculation agent, usually following a dealer poll to establish the price of the obligation

Cashflow CDO

- a CDO issued by a special purpose vehicle which owns a portfolio of debt securities. Senior investors start to be repaid before more junior investors if there is a decline in the value of the portfolio - defined as the sum of the par value of the performing collateral

CBO

(Collateralized Bond Obligation) - a CDO backed by or referenced to corporate bonds

Close-out

- in CPPI, a situation in which because of poor performance, the entire portfolio is allocated to the risk-free bucket. Also known as cashing out or hitting the cash floor.

CDO

(Collateralized Debt Obligation) - an investment collateralized by or referenced to a diverse portfolio of debt. The investor is exposed to losses above and below certain thresholds or once more junior classes of notes absorb losses. The collateral pools that are back CDOs can be static or managed. If managed, the manager receives a fee for advising on the composition of the portfolio and has discretion to recommend the sale and purchase of assets

CDO Squared (CDO^2)

- a CDO collateralised by or referenced to other CDOs. Most CDO squared are synthetic CDOs referenced to a portfolio of synthetic CDOs created specifically for that purpose

CDS

(Credit Default Swap) - an over-the-counter contract to transfer credit-risk, in which the buyer of protection pays a premium and the seller of protection makes a payment in the event of default

CDX

- A series of indices that track North American and emerging market credit derivative indexes. The purpose of the combined indexes is to track the performance of the various segments of credit derivatives so that the overall return can be benchmarked against funds that invest in similar products

Combination Notes

- a repackaging of CDO equity with a more senior tranche of the same deal. Typically, the principal of the note relies on the senior position to repay the principal, with the equity providing enhanced coupons. Combination notes usually have a principal-only rating

CLO

(Collateralised Loan Obligation) - a CDO backed by or referenced to loans

Constant Maturity Credit Default Swaps

- a credit default swap with a premium that is reset periodically in line with the prevailing spread of the referenced name or portfolio - or something in line with a credit derivative index

Copula

- a statistical tool describing how the distribution of single risks join together to form joint risk distribution. In the case of portfolio credit risk, copulas describe how patterns of individual default risk join together to form the distribution of loss on a portfolio

Correlation

- correlation is usually measured as a percentage, with 100% representing perfect correlation, 0% no relationship and -100% perfectly negative correlation

CPPI

(Constant Proportion Portfolio Insurance) - a cushioned- management technique involving asset allocation of investment notional between a risky and non-risky portfolio depending on the market value of the assets

Credit Swaption

- alternative name for a credit default swap option

Cushion

(Also Know as a Reserve) - in CPPI, the difference between the value of the portfolio and the floor. The amount that can be invested in risky asset (such as credit) is defined as a multiple of the cushion. When the value of the portfolio declines, risky assets are sold and the funds are invested in the risk-free assets (cash), thus deleveraging the structure

Delta

- the sensitivity of a derivative, such as an option, to changes in the reference price. In index tranches, the sensitivity of the tranche to change in the spread of the underlying names

Detachment Point

- the maximum level of losses in the portfolio too which a tranche is exposed

Down Jones CDX

- a suite of tradeable credit derivative indices referencing North American investment-grade corporates. North American high-yield issuers and emerging market borrowers. Tranches of the indices are also traded

Equity CDO

- a CDO where the reference assets are equities

Equity Default Swap

- a deep out-of-the-money barrier equity option documented to resemble a credit default swap

Expected Loss

- the expected value over a specified horizon of portfolio losses due to default

First-Loss Tranche

- the most junior tranche in a CDO or more generally, a tranched portfolio credit derivative with an attachment point of zero

Forward-Starting Synthetic CDO

- a CDO in which credit protection takes effect only after a certain period of time. The investor does not suffer losses as a result of the defaults prior to commencement of the credit protection

Floor (or Cash Floor)

- in CPPI, the amount below which the value of a portfolio is permitted to fall

Gap Risk

- the risk the market moves too quickly or is insufficiently liquid to allow positions to be hedged dynamically, especially a sudden widening in individual names when dynamically hedging a structured credit position (jump-to-default risk)

IC Ratio

(Interest Coverage Ratio) - in a CDO, the ratio of collateral interest to liability coupons. If the IC ratio falls below a certain level (the IC test), the CDO may be forced to deleverage

Implied Correlation

- the expected correlation of defaults in a portfolio derived from the price of a tranche and the price of the underlying credits

Implied Volatility

- the expected volatility in the return of an asset derived from its option price

Index Tranche

- a credit default swap referencing an index between standardised attachment and detachment points

Inner CDO

- inner tranche

Inner Tranche

- in synthetic CDOs squared, the bottom layer of a two-level synthetic CDO structure. Losses feed indirectly into the outer tranche through the inner tranches

Interest Coverage Ratio

see IC ratio

iTraxx

- a suite of tradeable credit derivative indices including iTraxx Europe (European investment-grade), iTraxx Asia ex-Japan (Asia borrowers) and iTraxx CJ (Japanese investment-grade). Tranches of the indices are also traded

Jump-to-Default Risk

- see gap risk

Leveraged Super-Senior Synthetic CD

- notes or sometimes swaps that absorb the first losses affecting a super-senior tranche and that are exposed to risks linked to the market value of a tranche

Loss Triggers

- in leveraged super seniors, margin call/unwind triggers linked to the amount of losses in a portfolio

Market Value CDO

- a CDO issued by a special purpose vehicle that owns a portfolio of debt or other securities. If there is a decline in the market value of the portfolio, the vehicle may be forced to sell assets and start repaying investors in descending order of seniority

Mark to Market

- a method of accounting for an asset based on the calculation of its current market value

Master Tranche

- see outer tranche

Merton Model

- also known as firm-value or latent variable model, the Merton model say default occurs when the value of a company's assets fall below the value of its debt. It therefore establishes a link between credit and equity prices

Mezzanine Tranche

- a middle layer of risk in a CDO or more generally, a tranched portfolio credit derivative with a risk profile higher than equity and lower than super senior

Nth-to-Default Basket

- a credit derivative in which the payout is linked to one in a series of defaults, such as first, second or third to default, with the contract terminating at that point

OC Ratio

(Overcollateralisation Ratio) - in a cashflow CDO, the ratio of the par value of the collateral to the CDO's liabilities. In a market value CDO, the ratio of the liquidity-weighted market value of the collateral to the CDO's liabilities. If the OC ratio falls below a certain level (the OC test), the CDO may be forced to deleverage.

Outer Tranche

- in synthetic CDOs-squared, the top layer of a two-level synthetic CDO structure. The outer CDO tranche references a portfolio consisting of the inner tranches

Overcollateralisation Ratio

- see OC ratio

Payer Option

- an option to buy credit default swap protection

Physical Settlement

- a payout following a credit event in which the protection buyer delivers an eligible obligation to the protection seller in exchange for the par value of the asset

Protection Buyer

- the counterparty that hedges credit risk in a credit derivative

Protection Seller

- the counterparty that assumes credit risk in a credit derivative

Put Option

- an option contract giving the the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within or at a specified time. For credit default swap options, a put option can be a put on risk (payer) or on protection (receiver)

Ramp-up

- the period in which a CDO manager selects assets to include in a CDO

Recovery Rate

- the value of the debt of an entity after it defaults

Recovery Swap

- a credit derivative with a fixed recovery rate resulting in an exchange of actual recoveries between the protection buyer and seller in the event of a default

Receiver Option

- an option to sell credit default swap protection

Reference Entity

- borrower whose default triggers a payment in a credit derivative

Reserve Account

- an account in a cashflow CDO where income from the assets are diverted in the event of a failure of IC, OC or other tests rather than being paid to tranche holders in premium (or thereabouts)

Sector Baskets

- standardised nth-to-default swaps traded on subsets of credit derivative indices

Spread Triggers

- in leveraged super seniors, margin call/unwind triggers linked to the weighted average spread of the underlying portfolio

Step-up CDO

- a CDO where the attachment and detachment points are not constant during the life of the CDO but typically increase each year

Structured Investment Vehicle

- a triple-A rated leveraged investment vehicle that seeks to maximise spread income through proactive management of its liabilities and assets

Subordination

- the amount of losses a portfolio has to experience before a tranche suffers any loss or the placing of one tranche below another in priority of payment

Super Senior

- a tranche with risk equivalent to better than a triple-A

Synthetic CDO

- a CDO where the reference assets may not exist as a real portfolio of assets supporting the CDO structure

Synthetic CDO Squared

- a credit derivative referenced to a tranche of a portfolio of reference assets, some or all of which are themselves are synthetic CDO tranches
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