Understanding Collateralized Debt Obligations (CDOs)

C

The correct statement among the options provided is C. "A CDO is typically structured into tranches, similar to a collateralized mortgage obligation (CMO)."

A collateralized debt obligation (CDO) is a type of structured asset-backed security. It is created by pooling together various types of debt obligations, such as corporate bonds, mortgage-backed securities, or other types of loans. These debt obligations are then divided into different tranches or layers of risk.

Tranches are portions or slices of the CDO that have different levels of risk and return. Each tranche represents a different level of seniority in the payment structure. The senior tranches have a higher priority of receiving payments and have lower risk, while the junior or equity tranches have a lower priority and carry higher risk but potentially higher returns.

The structure of a CDO into tranches allows investors to choose the level of risk and return that suits their investment objectives. It also enables the issuer to allocate the credit risk among different investors based on their risk preferences.

Option A, "The underlying securities for a CDO are typically issued only by U.S.-based entities," is incorrect. CDOs can include securities issued by entities from various countries, not just the United States. The underlying securities can be from different geographic regions and can include international debt obligations.

Option B, "A CDO with corporate bonds as the underlying security is known as a collateralized loan obligation (CLO)," is incorrect. While corporate bonds can be used as underlying securities in a CDO, a CLO specifically refers to a type of CDO where the underlying assets are loans made to corporations, rather than bonds.

Therefore, the most likely correct statement is option C, as it accurately describes the typical structure of a CDO into tranches, similar to a collateralized mortgage obligation (CMO).