Introduction

In this book we will introduce and describe in detail synthetic collateralised debt obligations (or synthetic CDOs for short). Synthetic CDOs are a sophisticated example of a more general asset class known as credit derivatives. In their simplest form credit derivatives facilitate the transfer of credit risk (the risk that a counterparty may fail to honour their outstanding debt obligations such as paying coupons or repaying principal on bonds they issued) between different counterparties to a trade. The rationale for trading credit derivatives is to allow this risk to be transferred efficiently between counterparties, from those who are unwilling or unable to hold it, to those who want it. This chapter will introduce some of the important credit derivative products that will be analysed in detail later in the book. The chapter will also introduce the financial engineering concepts that underlie synthetic CDOs.

Section 1.2 introduces the concepts of securitisation and tranching. These are the key financial innovations that underpin CDOs and indeed much of structured finance technology. Section 1.3 then provides an overview of some of the most common credit derivative instruments. These include credit default swaps, credit indices and most importantly synthetic CDOs.