Collateralized Debt Obligation or CDO is a derivative instrument that enables the repackaging of risky debt obligations and loans into financial security. In the legacy financial markets these instruments play a crucial role in the effective allocation of the credit risk in the market, enabling market participants on one hand hedge their positions, on the other hand, speculate on the credit risk. In the nutshell, CDO is designed from a pool of underlying instruments (called collateral), which are securitized in a way that assumes cash flow distribution prioritization based on the tranches. The securitized instruments for each tranch have different credit quality, which is determined based on the subordination level.
In the legacy financial market, the collateral of the CDO is composed from a portfolio of obligations or loans or other types of financial facilities (residential or commercial mortgages, leasing, lending, revolving facilities, and even other credit derivatives, etc). The pooling of the portfolio of obligations and tranching enables the development of a new class of securities that are characterized by different risk/return parameters.
The tranching in the context of CDOs is applied for the distribution of the risk between the investors based on their risk/return preferences. Overall, all the investors of CDOs take risks in terms of the possibility of the default of the underlying portfolio of loans. To ensure that the holdings of the investors are secured a portion of the premium paid by investors is used to compose tranch-based securities. The tranching mechanism assumes prioritizing structure, dividing the future cash flow distribution process into several layers, i.e. from subordinated tranches to the senior tranches. The subordinate tranches are designed to absorb the risk and losses, for the upper layer of tranches. In other words, the loss first affects on the most subordinate tranch and moves to the next layer as long as the subordinate tranch is exhausted. This enables investors to get exposure to tranch which risk level is more acceptable for them.
Based on this prioritization the interest rate and principle coming from the underlying is distributed to the investors of the CDO. This mechanism of loss distribution is called waterfall, imposing a particular structure in case of a default event.