Finance Terms

Structured Finance is a service that generally involves highly complex financial transactions offered by many large financial institutions for companies with very unique financing needs. These financing needs usually don't match conventional financial products such as a loan. Structured finance has become a major segment in the financial industry since the mid-1980s. Collateralized Bond Obligations (CBOs), Collateralized Debt Obligations (CDOs), syndicated loans and synthetic financial instruments are examples of structured financial instruments. Collateralized Bond Obligations (CBOs) is an investment-grade bond backed by a pool of junk bonds. Junk bonds are typically not investment grade, but because they pool several types of credit quality bonds together, they offer enough diversification to be "investment grade." Similar in structure to a Collateralized Mortgage Obligation (CMO), but different in that CBOs represent different levels of credit risk, not different maturities. Collateralized Debt Obligations (CDOs) is an investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often nonmortgage loans or bonds. Similar in structure to a CMO or CBO, CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays. Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus. Here is an example how a very simple CMO works: The investors in the CMO are divided up into three classes. They are called either class A, B or C investors. Each class differs in the order they receive principal payments, but receives interest payments as long as it is not completely paid off. Class A investors are paid out first with prepayments and repayments until they are paid off. Then class B investors are paid off, followed by class C investors. In a situation like this, class A investors bear most of the prepayment risk, while class C investors bear the least. Tranches is a piece, portion or slice of a deal or structured financing. This portion is one of several related securities that are offered at the same time but have different risks, rewards and/or maturities. "Tranche" is the French word for "slice". Tranche is a term often used to describe a specific class of bonds within an offering wherein each tranche offers varying degrees of risk to the investor. For example, a CMO offering a partitioned Mortgage Backed Securities (MBS) portfolio might have mortgages (tranches) that have one-year, two- year, five-year and 20-year maturities. It can also refer to segments that are offered domestically and internationally. Mortgage Backed Securities (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. Also known as a "mortgage-related security" or a "mortgage pass through". When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets. This type of security is also commonly used to redirect the interest and principal payments from the pool

of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS. Hedge is making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge). Hedge Fund is an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.