Synthetic CDO

A synthetic collateralized debt obligation (CDO) is a complex financial instrument that uses credit default swaps (CDS) to simulate the performance of a pool of underlying debt obligations, rather than directly holding the assets. Investors in synthetic CDOs do not own the actual debt but instead gain exposure to the risk and return of the underlying assets through derivatives. Synthetic CDOs were a major factor in the 2007–2008 financial crisis due to their high risk and opacity.

Example

An investment bank creates a synthetic CDO by selling credit default swaps on a portfolio of mortgage-backed securities, allowing investors to take on the risk without owning the actual mortgages.