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Collateralized Debt Obligation (CDO)

A Collateralized Debt Obligation (CDO) is a complex financial instrument that pools together various loans (such as mortgages, corporate debt, or credit card debt) and repackages them into different tranches based on risk. Investors in CDOs can choose tranches with different risk and return profiles. CDOs distribute payments from the underlying loans to investors in a way that reflects each tranche's risk level.

Example

An investor purchases a senior tranche of a CDO, which is backed by a pool of mortgages. The senior tranche has lower risk but offers a lower return compared to junior tranches, which carry more risk but higher potential returns.

Key points

• A CDO is a financial product that pools various loans and repackages them into tranches with different risk levels.

• Investors choose tranches based on their risk tolerance and desired returns.

• CDOs gained notoriety during the 2008 financial crisis due to their association with subprime mortgage loans.

Quick Answers to Curious Questions

A CDO is a financial instrument that pools loans and repackages them into tranches, each with different risk and return characteristics.

They are divided into tranches, with senior tranches offering lower risk and lower returns, while junior tranches carry higher risk and potentially higher returns.

Many CDOs were backed by subprime mortgages, and when these loans defaulted, it led to massive losses for investors, contributing to the financial crisis.