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FRM Exam Part II · An Introduction to Securitisation

Synthetic Securitisation and Credit Derivatives Explained

Updated 11 October 2026 · Fact-checked

Synthetic securitisation transfers the credit risk of a reference portfolio using credit derivatives, mainly credit default swaps, while the bank keeps the assets on its balance sheet. Protection can be unfunded (a CDS) or funded (credit-linked notes). To solve questions, identify who bears which tranche loss and what counterparty or collateral risk remains.

Understand Synthetic Securitisation and Credit Derivatives

In a cash securitisation, the originator sells loans or bonds to a special purpose vehicle (SPV). The SPV pays for them by issuing tranches to investors. Ownership of the assets moves. The credit risk moves with it.

In a synthetic securitisation, the assets are not sold. The originator keeps them and buys credit protection on a reference portfolio using credit derivatives. A credit default swap (CDS) pays the protection buyer when a credit event happens on a reference entity. The buyer pays a periodic premium (the spread). So the risk moves, but the legal title does not.

A synthetic CDO is built by tranching that risk. Losses on the reference portfolio are allocated in order: first to the equity (first-loss) tranche, then mezzanine, then senior and super senior. The sponsor often sells protection on each tranche through tranche-level CDS or a portfolio swap. Protection sellers earn the premium and bear the tranche losses.

The main split is funded vs unfunded. In an unfunded deal, the protection seller pays nothing upfront and only pays if losses hit its tranche. It carries the seller's counterparty risk. In a funded deal, the seller invests cash up front, often through credit-linked notes (CLNs) issued by an SPV. The cash is held as collateral in safe assets. Counterparty risk is lower, but the investor bears the full funding of the tranche. Many deals are partially funded: junior tranches are funded and the super senior is unfunded.

Why do banks do it? They can cut credit risk, free regulatory capital and avoid telling borrowers or needing their consent. Synthetic deals are faster and cheaper than cash deals. Their weaknesses are basis risk between the hedge and the actual loss, counterparty risk on the protection seller, and complexity. The pre-2008 market showed how concentrated super senior risk and correlation assumptions can fail.

Key formulas to remember

CDS premium payment
Annual premium = CDS spread × notional
Paid by the protection buyer, usually quarterly. Example: 100 bps on $50 million = $500,000 per year.
CDS protection payout (cash settlement)
Payout = notional × (1 − recovery rate)
Paid on a credit event. Physical settlement delivers the defaulted bond for par instead.
Tranche loss
Tranche loss = min(max(L − A, 0), D − A)
L is portfolio loss, A is attachment point, D is detachment point. All in the same units (money or % of portfolio).
Tranche thickness
Thickness = D − A
Thin tranches are highly sensitive to a small change in portfolio loss.
Credit triangle (approximation)
Spread ≈ PD (hazard rate) × (1 − recovery rate)
Rough link between a CDS spread and annual default intensity. It is an approximation, not an exact rule.

How to solve Synthetic Securitisation and Credit Derivatives questions

Use this order for any question on synthetic securitisation, CDS-based risk transfer or synthetic CDOs.

  1. 1Identify the reference portfolio and whether assets are sold (cash) or kept with risk hedged by derivatives (synthetic).
  2. 2List the tranches with attachment and detachment points. Convert percentages to money using the portfolio notional.
  3. 3Apply losses from the bottom up: equity first, then mezzanine, senior, super senior. Use min(max(L − A, 0), D − A).
  4. 4Compute any CDS flows: premium is spread × notional; payout on a credit event is notional × (1 − recovery).
  5. 5Decide funded or unfunded. Funded means upfront cash and collateral. Unfunded means a promise to pay, so counterparty risk.
  6. 6Name the remaining risks: counterparty risk, basis risk, correlation risk, and for the originator any capital relief conditions.
  7. 7Check the answer against the question wording: who is buyer, who is seller, and whose loss is being asked.

Quickest way: Tranche waterfall in four lines

When to use it: Use when a question gives a portfolio loss and asks which tranche takes how much, or asks about funded and unfunded features.

  1. Convert attachment and detachment points to money: A × notional and D × notional.
  2. Take the loss L. Tranche loss = zero if L ≤ A, full thickness if L ≥ D, otherwise L − A.
  3. For funded/unfunded, look for upfront cash and collateral. Cash invested means funded; a swap with no cash means unfunded.
  4. For the cash vs synthetic contrast, ask: did the assets leave the balance sheet? If no, it is synthetic.

Common mistakes in Synthetic Securitisation and Credit Derivatives

  • Saying a synthetic securitisation sells the assets to an SPV.

    It is confused with cash securitisation, where the true sale happens.

    Fix: In synthetic deals the originator keeps the assets. Only the credit risk is transferred through a CDS or similar.

  • Treating unfunded protection as free of counterparty risk.

    Students focus on the hedge and forget that the seller must pay later.

    Fix: Unfunded protection depends on the seller's ability to pay. Funded notes reduce this because cash collateral is held.

  • Applying losses to the senior tranche first.

    Mixing up seniority with where losses are absorbed.

    Fix: Losses start at the equity tranche and move up. Senior tranches are hit last.

  • Using notional instead of loss given default for the CDS payout.

    Forgetting recovery.

    Fix: Cash payout = notional × (1 − recovery rate) unless the question states a fixed payout.

  • Calculating a tranche loss as the full portfolio loss above attachment without capping at detachment.

    Ignoring the tranche's thickness.

    Fix: Cap the loss at D − A. Once the tranche is wiped out, further losses move to the next tranche.

  • Assuming synthetic deals remove all risk for the originator.

    Seeing the credit risk shifted and ignoring residual risks.

    Fix: Remember basis risk, counterparty risk and the possibility that the regulator does not grant full capital relief.

Worked examples

Example 1

A bank holds a $1 billion loan portfolio and buys credit protection through a synthetic securitisation. The mezzanine tranche attaches at 3% and detaches at 10%. Portfolio losses on the reference portfolio reach $60 million. How much loss does the mezzanine tranche absorb, and how much is absorbed by the equity tranche (0%–3%)?

Show the solution
  1. Convert attachment points: 3% of $1 billion = $30 million. 10% = $100 million.
  2. Equity tranche spans $0 to $30 million. Loss of $60 million exceeds $30 million, so equity loses its full $30 million.
  3. Mezzanine loss = min(max(60 − 30, 0), 100 − 30) = min(30, 70) = $30 million.
  4. Check: $30 million + $30 million = $60 million, which equals the portfolio loss. The senior tranche takes zero.

Answer: Equity absorbs $30 million (wiped out). Mezzanine absorbs $30 million. Senior absorbs nothing.

Example 2

A bank buys unfunded CDS protection of $40 million on a reference entity at a spread of 150 bps per year. The entity defaults, and the recovery rate is 35%. Find the annual premium and the cash settlement payout. Is this structure funded or unfunded, and what main risk does the bank bear?

Show the solution
  1. Annual premium = 1.50% × $40 million = $600,000.
  2. Payout = notional × (1 − recovery) = $40 million × (1 − 0.35) = $40 million × 0.65 = $26 million.
  3. A CDS with no upfront cash from the seller is unfunded.
  4. The bank still faces counterparty risk: if the protection seller cannot pay, the bank does not receive the $26 million.

Answer: Premium is $600,000 per year. Payout is $26 million. The structure is unfunded, so the bank bears counterparty risk on the protection seller.

Exam tips

  • Read who is buying and selling protection. Many wrong options reverse the roles.
  • Expect the cash vs synthetic difference to be tested through one fact: assets stay on the balance sheet in synthetic deals.
  • For funded vs unfunded, look for collateral and upfront cash. These point to funded structures and credit-linked notes.
  • In tranche questions, do the arithmetic in money, not percentages, and cap at thickness.
  • Link the topic to the 2008 crisis: correlation assumptions and concentrated super senior exposure are common case themes.

Practice questions from An Introduction to Securitisation

Synthetic Securitisation and Credit Derivatives: frequently asked questions

What is the difference between a cash CDO and a synthetic CDO?

A cash CDO holds actual bonds or loans bought with money raised from investors. A synthetic CDO gets its credit exposure through credit default swaps, so no assets are bought or sold. Synthetic deals can be larger and faster to set up.

What is funded vs unfunded synthetic securitisation?

In a funded deal, investors pay cash up front, often through credit-linked notes, and that cash backs their obligation. In an unfunded deal, the seller only promises to pay on a loss, usually through a CDS. Unfunded protection carries counterparty risk.

Why do banks use synthetic securitisation?

They transfer credit risk and may reduce regulatory capital without selling loans or involving borrowers. It is usually cheaper and faster than a cash deal. Capital relief depends on regulators accepting the risk transfer.

Who bears losses first in a synthetic CDO?

The equity tranche bears losses first, then the mezzanine, then senior and super senior tranches. Each tranche is hit only after the tranches below it are exhausted.