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FRM Part II · FRM Exam Part II · Credit Risk

A risk manager compares a cash CLO with a synthetic CLO that references the same loan portfolio. Which statement correctly describes a key difference?

A synthetic CLO transfers credit risk using credit default swaps, so the originator does not have to sell the underlying loans. A cash CLO involves a true sale to an SPV funded by investors. Synthetics still carry counterparty risk, so it is not eliminated.

  1. AThe synthetic structure transfers credit risk through credit default swaps without requiring the sale of the underlying loansCorrect
  2. BThe synthetic structure requires the originator to sell the loans to a special purpose vehicle
  3. CThe cash structure transfers credit risk without any funding of the tranches
  4. DThe synthetic structure removes all counterparty risk because no assets are transferred

Explanation

Synthetic securitizations use credit derivatives to transfer the portfolio's credit risk while the originator keeps the loans on its balance sheet. Cash structures involve a true sale and fund tranches with investor cash. Synthetics do not eliminate counterparty risk, since protection depends on the CDS counterparty or collateral arrangements.

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