Arbitrage Collateralized Debt Obligations (CDOs) buy bonds, mortgages, commercial loans and other CDOs and sell securities to investors. Their main creators are money managers that earn fees on the assets under management. The CDOs make money on the spread in interest between the assets in the CDOs and the interest that the CDOs pay to their investors. Like the balance sheet CDO, arbitrage CDOs may be cash-funded or synthetic.
Cash-funded arbitrage CDOs can be structured as cash flow or market value. The cash flow CDO holds a portfolio of assets and receives interest and principal payments. It issues securities that have the same payment schedule and maturity dates as the portfolio. The CDO uses its receivables to pay its investors. The cash flows of the CDO are dependent on the default and recovery rates of the assets. Most of the time, the CDO manager can trade the assets of the portfolio to increase the return and to reduce the risk of loss due to defaults of the underlying assets.
The market value CDO also holds a portfolio of assets and issues securities to investors. It is used when the payment schedule and maturity dates of the assets and securities are not the same. The cash flows of the CDO are dependent on the interest payments and the selling of bonds to make principal payments. They are also affected by the default and recovery rates of the assets.
Synthetic arbitrage CDOs use a swap (credit default or total return credit) to transfer the risk of an asset without owning it. The CDO will receive swap payments every quarter. It will pay the money manager LIBOR + spread and receive the total return on the CDO's assets. From the total return, it will pay out to its investors.
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