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A synthetic collateralized debt obligation (CDO) is a multi-layered derivative product designed essentially for credit risk transfer purposes. It allows a diversified group of investors to gain exposure to a pool of debt instruments to obtain a profit. Derivative means that it is derived from reference/underlying assets, and in this case, these are miscellaneous debt instruments. In a synthetic CDO transaction, the reference assets are not transferred to the investors. This means that they assume all of the risks associated with the product without owning the underlying assets.
Fundamentally, the CDO is some type of asset-backed security (ABS), which can be backed by an assorted pool of debt instruments, such as various kinds of bonds, bank loans, residential mortgage-backed securities and many more. If the pool is comprised of bond-type instruments, the CDO is called a collateralized bond obligation (CBO). The CDO is also designated as a collateralized loan obligation (CLO) if the underlying pool is composed of bank loans. A CDO derivative is sold to investors just like any other debt security.
The CDO is processed further to create the synthetic CDO, which is backed by a credit derivative such as a credit default swap (CDS). Typically, a CDS is created to act as an insurance policy. For instance, a bank will issue a mixture of mortgages, bonds and other sorts of debt to many individuals and/or institutions. The bank will then buy a CDS from an investor as a protection to counter any credit events pertaining these debts, which include defaults, repudiation, restructuring and others. The bank will make a periodic payment or a one-off premium payment as stipulated between it and the CDS sellers or investors, and in the case of a credit event, the investors are supposed to compensate for the loss.
The synthetic CDO can be tailored to cater to a diverse group of investors with distinct risk appetites. This explains the several levels of risk and return that are present in the structure of the synthetic CDO. The return is commensurate to the risk assumed; that is, low risk equals low return, and high risk is likely to create high return. Moreover, because these levels are relatively scaled in order, from safe to riskier, the investors who take on less risk will be paid before the ones who assume more risk. Furthermore, the proceeds from the sale of the CDO securities can be funneled into other less-risky securities.
Those who manage and/or market the CDO are called sponsors. Given the sponsor's particular motivation, the synthetic CDO will additionally be carved into balance sheet CDO or arbitrage CDO. In the former instance, the sponsors are seeking to remove assets from their balance sheet. Banks also use this method to significantly reduce the capital requirement imposed by regulation. In an arbitrage CDO, their goal is to derive a fee from managing the assets of the CDO and/or collect a profit from the difference between the cost of financing the underlying assets and any additional return realized therefrom.
Also, the synthetic CDO will usually be an intermediary between one or more protection sellers and one or more protection buyers, resulting in an even more complex structure. Basically, the investors are the credit protection sellers, and on the opposite side of the transaction are the buyers. The investors receive premiums from the protection buyers, and they will pay for the loss incurred to the buyers in the case of a credit event.
There also is a niche synthetic CDO product called a single-tranche CDO, also referred to as a bespoke CDO. This transaction is inherently very private and highly customized to fit the investor's preference. Moreover, there is a benchmark called the weighted average rating factor (WARF), which is used to measure the quality of the underlying assets in the CDO market.