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FRM Part II · FRM Exam Part II · Structured Credit Risk

A risk manager compares a cash CDO with a fully unfunded synthetic CDO that references the same portfolio of corporate credits. Which is a key difference between the two structures?

A synthetic CDO transfers credit risk through credit default swaps, so the sponsor retains legal ownership of the reference assets, and in an unfunded structure the protection seller faces counterparty risk to the buyer. A cash CDO instead sells the assets to a vehicle. Both are tranched and correlation-sensitive.

  1. AThe synthetic CDO requires the sponsor to sell the reference assets to a special purpose vehicle, while the cash CDO does not
  2. BThe synthetic CDO transfers credit risk through credit default swaps, so the sponsor keeps legal ownership of the reference assets and investors face counterparty exposure to the protection buyerCorrect
  3. CThe cash CDO has no tranching, whereas the synthetic CDO is always tranched
  4. DThe synthetic CDO has no exposure to correlation among reference names, whereas the cash CDO does

Explanation

Synthetic CDOs transfer risk via CDS rather than sale of assets, so the originator retains the assets, and in an unfunded structure the protection seller is exposed to the buyer's counterparty risk. Both structures are tranched and both are sensitive to default correlation.

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