Credit Risk Management Practice Exam

What primarily characterizes a synthetic CDO?

1. It transfers credit risk to the originator

2. It issues securities directly backed by cash flows

3. It retains reference assets on the originator's balance sheet

4. It does not involve any credit derivatives

The correct answer is: It retains reference assets on the originator's balance sheet

A synthetic CDO (Collateralized Debt Obligation) is characterized primarily by its use of credit derivatives to construct its portfolio. In a synthetic CDO, the underlying assets are not physical loans or bonds; instead, the credit exposure is created through instruments such as credit default swaps (CDS). This means that a synthetic CDO allows an entity, often a bank, to take on credit risk associated with a set of reference entities without having to own the actual loans or bonds related to those entities. The reference assets remain on the originator's balance sheet, but the risk is transferred to other investors who purchase the CDO's securities, usually in the form of tranches reflecting different risk levels. The other options do not accurately capture the essence of a synthetic CDO. It does not primarily transfer credit risk back to the originator, nor does it issue securities directly backed by cash flows from loans or it would involve actual credit derivatives, which is contrary to the nature of a synthetic CDO. The key characteristic to focus on here is that the reference assets are retained on the originator's balance sheet, which allows them to manage their risk exposure differently than in traditional cash flow CDOs.