What is CDS and CDO?

Credit default swaps (CDS) and collateralized debt obligations (CDO) are both types of derivatives. Derivatives can be used to “hedge” or mitigate the risk of economic loss arising from changes in the value of the underlying item. (“naked CDS”) or hedging (“non-naked CDS”).

How are CDS traded?

CDS are traded over-the-counter (OTC)—meaning they are non-standardized and not verified by an exchange—because they are complex and often bespoke. There is a lot of speculation in the CDS market, where investors can trade the obligations of the CDS if they believe they can make a profit.

Are CDS collateralized?

Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency. A CDS can be unsecured (without collateral) and be at higher risk for a default.

What happens to a CDO when it is sold to investors?

When various debts, like corporate bonds or mortgage-backed securities, are pooled together, it creates a new security: a CDO. The CDO is then separated into various “tranches,” or levels of risk, and then each tranche is sold to investors. “What actually happens … is you have a pool of corporate credits.

What does CDO stand for in the Big Short?

The third part of the Big Short Case Study. This post traces the origin of the mortgaged backed CMO CDO CDS product sets referenced in the book and the film. The terms stand for Collateralize Mortgage Obligation (CMO), Collateralize Debt Obligation (CDO) and Credit Default Swap (CDS). A family buys a home using a mortgage loan from a bank.

What kind of CDOs do hedge funds invest in?

Bespoke CDOs usually invest in credit default swaps. Disgraced due to their pivotal role in the 2007-09 financial crisis, bespoke CDOs began reappearing in 2016 as bespoke tranch opportunities. Bespoke CDOs are mainly the province of hedge funds and other institutional investors.

What kind of collateral is a CDO backed by?

A structured finance CDO, or SFCDO, is backed primarily by structured products like asset-backed and mortgage-backed securities. Collateralized synthetic obligations, or CSO, are backed primarily by credit derivatives like CDS.