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A collateralized debt obligation (CDO) is a security that is backed by or linked to a diversified pool of credits. The credits can be assets, such as bonds or loans, or simply defaultable names, such as companies or countries. In general, there are two types of CDOs: cash CDOs and synthetic CDOs. A cash CDO is backed by “true” assets, such as bonds or loans. Its payoffs, either coupons or principals, come from the actual cash flows of the assets in the pool. Synthetic CDOs are not backed by cash flows of assets. Instead, they are linked to their reference entities by credit derivatives, such as credit default swaps. The payoffs of most synthetic CDOs are only affected by credit events, e.g., defaults, of the reference entities and are not related to the actual cash flows of the pool.

A common structure of CDOs involves slicing the credit risk of the reference pool into a few different risk levels. A “slice” of credit risk, the credit risk between two risk levels, is called a tranche. The tranche that absorbs the first loss piece is often called an equity tranche. The remaining tranches are called mezzanine or senior tranches. Tranches with higher credit risks support the tranches with lower credit risks.

A typical feature of a cash CDO is the so-called cash flow waterfall structure where a tranche is paid for its coupon and/or principal only if all the tranches with lower credit risk have been paid off. Such a feature requires a match between the incoming coupons and principals of the pool and the payouts of the tranches. Most synthetic CDOs don’t have a cash flow waterfall structure. Synthetic CDOs are only concerned with the default loss. This simplified structure makes structuring, managing and valuing synthetic CDOs easier than cash CDOs. The important implication of such a simplified CDO structure is that tranche customization is possible. Since the payoffs of one tranche don’t depend on the payoffs of other tranches, it is easy to structure CDOs with any types of tranches, based on an investor’s risk appetite. This makes synthetic CDOs attractive to both CDO investors and managers and has helped the rapid development of the CDO market.