Cash vs Synthetic Structures Synthetic CDO structures involve the use of credit derivatives.

Arbitrage Transactions TranchePar ValueCoupon ValueCoupon Rate Senior$80,000,000FloatingLIBOR+70 basis points Mezzanine$10,000,000FixedTreasury rate basis point Subordinate/Equity$10,000,000 Create an arbitrage CDO is whether a structure can offer a competitive return for the subordinate/equity tranche as below:

Assumptions The collateral of the CDO: bonds that all mature in 10 years The coupon rate for every bond is a fixed rate The fixed rate at the time of purchase of cash bond is the 10 year treasury plus 400 basis points To finance the senior tranche, collateral manager enters into an interest-rate swap with another party with a notional principal of $80 million in which it agrees to do the following: Pay a fixed rate each year equal to the 10-year Treasury rate plus 100 basis points Receive LIBOR

Cash flows Assuming the 10-year rate at the time the CDO is issued is 7%. Interest received from collatoral: Interest to senior tranche: Interest to mezzanine tranche: Interest to swap counterpart: Interest received from swap counter part As a result, Total interest received: Total interest paid: Net interest

Synthetic CDOs In a synthetic CDO, the collateral absorbs the economic risk associated with specified assets but does not have legal ownership of those assets Requires the use of CDS