Example on cash flow diagram, Financial Management

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(a) A usual cash flow diagram will incorporate the following. If you are short the CDO and then you receive a fixed amount at the initial point to. After that you make payments made of a floating risk-free rate plus a fixed spread. Nevertheless if one or more of the underlying credits default your share of the defaulted amount will be deducted from the coupon.

(b) Ever since you are receiving a spread over a floating rate the interest rate risk is minimal. There are a few risks only between the coupon payments dates. This is able to be hedged using strips of FRA's. Or else by using swaps as the reading suggests.

Or else the CDO is an investment vehicle and the investor is exposed to changes in the credit curve. If necessary such risks are able to be hedged by taking positions on a proper set of CDSs.

(c) A refuse of the overall level of interest rates means the floating rates are going down. If the investor is hedged trough the FRA's this will have no effect on the overall returns. Alternatively if default rates increase the value of the CDO will decline.

(d) As underlying credits default this will reduce the principal amount involved in the CDO during its life cycle. Alternatively if such a CDO is hedged using a swap and the swap notional will remain fixed

This signifies that a plain vanilla swap will end up introducing a basis risk. But a customized swap where the swap notional decreases as CDO principal changes will be more expensive.


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