Risk involved in CDOs
CDOs are structured products and just like other financial products hence are also subject to various types of Risk.
The main types of risk associated with investment in CDOs are as follows:
(1) Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying party to the instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall.
(2) Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis of interest rates. For example, asset may be based on floating interest rate but the liability may be based on fixed interest rates. Though this type of risk is quite difficult to manage fully but commonly used techniques such as swaps, caps, floors, collars etc. can be used to mitigate the interest rate risk.
(3) Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity risks as there may be mismatch in coupon receipts and payments.
(4) Prepayment Risk: - This risk results from unscheduled or unexpected repayment of principal amount underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and the debtors have a call option. Since, in case of falling interest rates they may pay back the money.
(5) Reinvestment Risk: - This risk is generic in nature as the CDO manager may not find adequate opportunity to reinvest the proceeds when allowed for substitutions.
(6) Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from countries other than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also subject to the foreign exchange rate risk as discussed in the paper Strategic Financial Management.
No comments:
Post a Comment