Synthetic Collateralized Debt Obligation
What it is:
A synthetic collateralized debt obligation is a collateralized security which is backed by derivatives such as swaps and options contracts.
How it works (Example):
A synthetic collateralized debt obligation, commonly called a synthetic CDO, seeks to generate income from swap contracts, options, and other non-cash derivatives rather than straightforward debt instruments such as bonds, student loans, or mortgages. Similar to other types of CDOs, synthetic CDOs are issued in graduated tranches of relative risk, with unsubordinated tranches bearing the highest risk without an initial investment and subsequent subordinated tranches requiring an investment and bearing lower risk. Holders receive payments derived from the cash flow associated with comprised swaps and from options and insurance contract premiums.
Why it Matters:
In addition to providing investors with an income option, synthetic CDOs reduce the risk associated with carrying high volumes of loans by engaging in derivatives such as swaps, insurance contracts, and options. By packaging these options as the backing for a CDO, the issuer can transfer a portion of the risk to investors while generating income from the CDO's sale. Investors in synthetic CDOs should be aware, however, that though they may have paid for only a portion of their potentially phenomenal returns, they take on all liability for any payment defaults, the penalties for which can be equally burdensome.