CPDO For Dummies
CPDO :: Constant Proportion Debt Obligations
How it works:
The deal : You put x millions into a CPDO and you could earn Libor + n bps say 200 bps.
The bank side:
The money goes into deposit ,earns Libor and serves as a collateral to write protection on some index DJ CDX and/or iTraxx with 5 years maturity.The bank will write protection for the first 6 months and roll to the next version of the index with 5 years to maturity,every 6 months.
This is done with some leverage ,say 10 times x millions.So if the premium is 25 bps on the index ,you get 250 bps,ceteris paribus,ex-costs :management ,spreads, front running etc…
Next,at each roll,the bank either has earned more than enough to pay the coupon [Libor + 200 bps],in which case the extra return is added to the deposit,or not enough to pay the coupon in which case,it will still pay the coupon by reducing the deposit.
The bank carries on doing this until the deposit is big enough to guarantee,coupons + principal to maturity or until the deposit is 90% gone.
With a CPDO rebalancing is roughly inverse to that of a CPPI {Constant Proportion Portfolio Insurance} if leverage is greater than 1.
Here is how a major credit rating agency describes the rebalancing process:
To understand how the CPDO works, we can draw a parallel with a simple coin-toss game. The outcome of the toss is either “heads” or “tails”. Heads results in a 100% return and tails a 100% loss.
The player has an initial stake of 1000, comprised of 100 from his own pocket and 900 borrowed from a friend. At the outset his strategy is as follows: if he succeeds in converting his stake into 2000 of winnings, he will stop and reimburse his friend, having thus multiplied his initial investment by 11. This corresponds to the Cash-In Event.At the same time, his friend is concerned about his stake and thus if the player loses more than 100, he will stop playing. This corresponds to the Cash-Out Event. (For each toss, the player bets 1% of the difference between his current stake and 2000–the simple rebalancing rule in our example.)
If he bets 10 from the initial stake on “heads”, there are two possible outcomes:
− “Heads”: the player’s stake rises to 1010, so at the next round he will bet only 9.90.
− “Tails”: he now has only 990, so at the next round he will bet 10.10.
Such a strategy is based on the notion that if “heads” has appeared more frequently than expected, it is less likely to continue appearing, and similarly for “tails.” In other words, the strategy is based on the concept of “mean reversion.”
Or rather on the gambler’s fallacy.
Trader talk:
“If I know all these CPDOs are going to have to buy protection on the old index before it rolls, I’m going to drive out spreads in the days before the roll,” said one trader, adding traders also would drive spreads tighter on the new indices. Excessive spread widening on off-the-run indices in the run-up to the roll could create mark-to-market losses for CPDOs. This could be compounded by spread tightening in new indices, which would deny CPDOs a sufficient carry to compensate for MTM losses. Traders pointed to the roll from CDX.IG.4, which contained downgraded auto companies General Motors and Ford Motor Co., into IG.5 as an example of negative carry.
Update 15/11/2006:CPDOs Are Derivatives Market’s New Alchemy Trick by Mark Gilbert at Bloomberg
It starts like this:
“Dear Sir/Madam, your details were provided by someone who is assuring me of your honesty and integrity for an Urgent Business Proposal in Confidence of the Strictest Nature. I am the sales director of the Democratic Republic of Derivatives. Unbeknownst to my colleagues, I have discovered millions of dollars hidden in an unexplored corner of the republic in the form of Constant Proportion Debt Obligations, or CPDOs. I seek your assistance in unlocking this value for the benefit of both of us.”…….They [CPDOs] have the distinct whiff of a Nigerian banking-scam e-mail, with the marketing literature suggesting the newfangled securities have found the holy grail of investing — heads you win, tails you don’t lose……The most innovative feature of a CPDO is its resemblance to a gambler at a casino, doubling up when bets go awry by shifting chips from the safety of the pile in front of him to the danger of the baize……..A truism of financial markets is that everyone agrees there’s no such thing as a free lunch — until they think they have spotted a buffet of risk-free basis points. CPDOs look too good to be true, so guess what? They probably are.
+ A typical prospecus of a recent CPDO offering here ABN-AMRO
+ CPDOs:the new best seller? Citigroup
+ CDPO an asset class on its own or a glorified bearish Rated Equity? UBS
+ 01/12/2006: Financial wizards’ debt to ratings agencies [FT]
+ 17/11/2006: CPDOs? Is the bar being lowered? Deutsche Bank
+ 14/11/2006: Questions lie behind CPDO hype at FT
Other posts:
Bill Gross on CPDO
CPDO
Credit Derivative Option for the Masses