What is a synthetic CDO primarily composed of?

A synthetic CDO, or collateralized debt obligation, is primarily composed of a basket of credit default swap (CDS) contracts. Unlike traditional CDOs that are backed by actual physical assets or cash securities, synthetic CDOs gain exposure to credit risk through derivatives like credit default swaps. This allows investors to take on credit risk without the need for owning the underlying loans or assets.

The use of CDS contracts enables synthetic CDOs to provide investors with leveraged exposure to a portfolio of credit risk by referencing various entities or debt instruments. This can be particularly appealing to investors looking to benefit from potential credit events without the associated capital tied up in physical securities.

Ultimately, the structure of synthetic CDOs allows for more flexibility and customization in terms of risk exposure and investment strategies, making them distinct from other types of investments that rely on direct ownership of the assets.