Collateralized debt obligation

Collateralized option

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A top down collateralized option of cash flows from Senior down to Equity A bottom up distribution of losses from Equity up to Senior Hedging Methods Static Leverage With Knock-Out Structures The amount of leverage is fixed from the inception date and remains unadjusted over the entire investment duration, unless there is a knock-out trigger event, in which case the structure is terminated prior to maturity.

In most of the structures, the management of the principal protection given to the most senior debt holders is in fact implemented through the use of pre-defined levels and not using a single knock-out level.

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These levels are designed to trigger progressive adjustments of the leverage amount to prevent early termination events. The de-leveraging of the fund exposure and therefore the participation rate of the equity securities is triggered by liquidating a pre-defined amount of hedge fund underlying assets, whenever the fund fails to comply with the over-collateralization ratio with respect to a certain class of debt.

The proceeds from such a liquidation are collateralized option to either reduce the debt outstanding by the equivalent amount or to increase the liquidity allocation, in both cases to reduce the risk and get the ratio back to an acceptable level. Under certain conditions of fund recovery, the structure may be re-leveraged or additional senior asset classes would be re-issued.

Collateralized debt obligation overview

Certain scenarios such as a severe depreciation, could knock-out the structure, leading to early redemption. Dynamic Leverage using Restrikable Options The amount of leverage is constantly adjusted over the investment duration. Assets are allocated between i riskless assets and ii equity interests. The amount allocated to the riskless assets corresponds to the amount necessary to fully defease the payment obligation given to the debt holders at maturity.

This is used to purchase zero-coupon type instruments or equivalent.

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No change in the investment in the riskless collateralized option occurs until maturity, regardless of the funds' performance. The outstanding amount of the proceeds, together with a fixed amount of additional proceeds the leveraged amount, equal to a fixed multiple of the outstanding proceedsfrom the issuance of the debt securities, is invested in the collateral to generate the return on the equity securities. Thereafter, the allocation to the fund is systematically adjusted up or down, depending on the collateral performance collateralized option the over-collateralization ratio requirements.

Due to the nature of the riskless assets allocation, this structure is sensitive to interest rate levels from a mark-to-market prospective and would suffer in a rising interest rate environment.

Collateralized Debt Obligation (CDO)

Dynamic Leverage Using Dynamic Allocation The leverage amount given to the equity investors depends on a pre-defined formula and performed dynamically through the use of portfolio insurance techniques. The principal protection given to the senior debt securities is granted at maturity, through the implementation of dynamic rebalancing operations between two different classes of assets: i trading assets fund shares and ii liquid collateralized option money market instruments.

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The portion allocated to fund shares at any time is equal to the "leverage factor" multiplied by the difference between i the net-asset value of the collateral and ii the value of the riskless assets that would be required to defease the principal amount of the most senior debt securities at maturity. The leverage depends on factors such as the collateral volatility, liquidity and transparency and is decided at inception.

Unit: Options, swaps, futures, MBSs, CDOs, and other derivatives

The value of the riskless assets is re-calculated on each rebalancing date and a function of the interest rate for the time remaining to maturity. Such path-dependent structures have no sensitivity to interest rates from a mark-to-market standpoint.

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Unlike U. They do not therefore require collateralized option separate stand-alone rating from a rating agency.

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The advance rate corresponds to collateralized option percentage of assets required as collateral to issue rated debt. The class of debt investments that has the higher advanced rate shall be the BBB rated notes: having the lower rating, more collateral is needed. The sum of the assets market value times the advance rate shall remain greater than the total outstanding principal plus interests, otherwise the manager has to adjust back collateralized option portfolio over a so called "cure period" to get the collateralization test back within the predefined limits.

The over-collateralization ratio is used to improve the credit enhancement of the debt tranches.

Collateralized debt obligation

It is defined collateralized option transaction inception, by the rating agency rated or the debt issuer unratedas the ratio of a the fund's net-assets value and b the sum of i the outstanding amount of a certain class of debt, ii the aggregate outstanding amount of all the other classes of debt tranches senior to the collateralized option class of debt and iii all applicable accrued and unpaid expenses and interest costs of the fund. A test failure leads to the diversion of subordinated cash flows to restore the ratio within acceptable limits.

The waterfall defines the priority of payments between the different tranches and therefore the credit enhancement.

Interest waterfall: the payment of interest to a tranche is subordinated to the payment of interest to the senior classes, and Principal waterfall: the redemption of a tranche is done only if the senior notes have been fully redeemed. The breakeven rate of return is the internal rate of return level required on the underlying assets to extract a real benefit from the leverage, meaning to cover at least the weight and costs of the funding as well as the other costs of the CFO structure.