Arbitrage CDOs

As discussed, CDOs are generally categorised as either balance sheet CDOs or arbitrage CDOs depending on their intended purpose. In terms of operating mechanics, balance sheet CDOs are almost exclusively cash-flow-based while, arbitrage CDOs are structured either as cashflow-based or market-value-based. A later development, synthetic CDOs, now account for a growing number of transactions. 

The appropriateness of either model (cash-flow-based versus market value-based) will depend on the asset manager s trading style as well as the particulars of the asset class the asset s market liquidity, duration profile, and credit spread volatility. In terms of mechanics, cash flow arbitrage CDOs are no different than balance sheet CDOs, (again, the only difference being their intended pnrpose and asset sourcing strategy). Consequently, one should see the section on Balance Sheet CDOs for further details. Now, we shift the discussion to market value CDOs. 

Euro Zing I is a cash flow CDO that presents several features of novelty and interest. It is the first true arbitrage CDO of European asset-backed securities in that, 100% of the assets were sourced from the marketplace rather than an existing balance sheet. It is also the first CDO to use a unique, innovative dnal-currency liability structure in sterling and euro to access the sterling ABS market in a cost-efficient way as opposed to cnrrency swapping each asset individnally to a common cnrrency. 

The period 2005 to first half2007 was a period of very high growth for the issuance of CDOs. During this period the growth in the CDO product was investor-driven and high volumes of arbitrage CDO transactions were issued. However, a big impact of the credit crunch from 2007 has been a sharp decline in new issuance of CDO product. 

FIGURE 16.5 Issuance Data Volumes, Arbitrage CDO, and Ralance Sheet CDO ... 

The first European synthetic transactions were driven by bank originators with the nnderlying reference assets being commercial loans on the originator s balance sheet. Arbitrage synthetic CDOs have also been sponsored. Within the synthetic market, arbitrage-based transaction were the most freqnently issued during 2001. 

There are many reasons why an investor may decide to invest in an ABS or a CDO, e.g., to exploit arbitrage opportunities targeting higher returns, to move assets off its balance sheet, to raise cost effective funding, to get exposure to a variety of risk profiles, and so on. ... 

CDOs of both types are also categorized by the motivation behind their creation. The two main categories are issuer- or balance sheet-dnven transactions and investor-driven or market value arbitrage transactions. 

Different types of institutions have different motives for originating CDO transactions. The main ones are to optimize regulatory capital, to obtain funding, to engage in arbitrage, or, on occasion, a combination of all three. 

The profitability of an arbitrage-driven CDO depends on such factors as the following ... 

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