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

A risk manager compares a cash CLO with a fully unfunded synthetic CDO referencing a similar loan pool. Which of the following is a feature distinguishing the synthetic CDO?

A synthetic CDO transfers credit risk through credit default swaps instead of selling the underlying loans. The originator keeps the assets and client relationships on its balance sheet while investors, as protection sellers, bear tranche losses from reference entity defaults. Cash CLOs, by contrast, rely on a true sale of assets.

  1. AThe issuer must physically sell the reference loans to a special purpose vehicle, causing true sale of assets
  2. BCredit exposure is transferred via credit default swaps, so the originator can retain the loans on its balance sheet while transferring credit riskCorrect
  3. CInvestors are exposed only to interest rate risk, not to credit risk of reference entities
  4. DTranche losses are determined by prepayment speeds rather than defaults

Explanation

A synthetic CDO transfers credit risk using CDS (protection sold by investors on tranches) rather than a transfer of the underlying assets. This lets the originator keep the loans and customer relationships. True sale is a feature of cash structures, and investors remain exposed to credit losses.

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