This chapter begins by reviewing some pertinent aspects of asset-backed securities (ABS) and collateralized debt obligations (CDOs), including the CDO tranche structure, expected loss, premium and liability legs, spread, mark-to-market, and risky duration. The chapter discusses trading strategies, including detailed mathematical descriptions, based on CDO carry trades involving Delta-hedging a long equity tranche of a CDO with a short CDS index position, Delta-hedging a short senior/mezzanine tranche with a long index position, Delta-hedging a long lower quality tranche with a short higher quality tranche, or Delta-hedging a tranche with a single-name CDS, CDO curve trades such as steepeners and flatteners, including notional-neutral, risky duration-neutral, and carry-neutral trading strategies, and mortgage-back security (MBS) trading strategies, which deal with the mortgage prepayment risk.
KeywordsAsset-backed security (ABS) Collateralized debt obligation (CDO) CDO tranche Expected loss Premium leg Liability leg CDO spread Mark-to-market Risky duration CDO carry trades Delta-hedging CDS index Single-name CDS CDO curve trades Steepener Flattener Mortgage-back security (MBS) Attachment point Detachment point CDO notional Reference entities Delta Index hedging MBS passthrough Prepayment risk
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