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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

In a funded synthetic CLO, an originator buys protection on a USD 1,000 million reference portfolio. The SPV issues credit-linked notes and invests the proceeds in AAA government securities. Compared with an unfunded structure using a credit default swap directly with a protection seller, what is the main credit-risk advantage of the funded structure for the originator?

The funded structure lowers counterparty risk on the protection provider. Investors pay cash upfront, which the SPV holds in safe securities, so funds are available to pay the originator if losses occur. It does not remove basis risk or ensure capital relief.

  1. AIt removes the originator's market risk on the reference loans
  2. BIt reduces the counterparty risk on the protection seller because the collateral is posted upfrontCorrect
  3. CIt eliminates basis risk between the reference portfolio and the hedge
  4. DIt guarantees that regulatory capital relief will be recognised

Explanation

In the funded structure the investors' cash is held in the SPV as high-quality collateral, so the originator's protection is backed by assets and does not depend on the seller's later ability to pay. Basis risk and market risk on the loans are unchanged, and capital relief depends on regulatory criteria.

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