What is structured finance & how does it works

structured finance & how it works

1. What is structured finance and how does it work?

2. Structured finance is a complex financial engineering technique that involves creating new financial instruments by pooling and repackaging a variety of underlying assets. These assets can include loans, mortgages, credit card receivables, or even intellectual property . Here's a breakdown of how it works: Asset Pooling: A group of assets with similar characteristics are combined into a pool. Securitization: This pool of assets is then used to create new securities, often called asset-backed securities (ABS). Tranching : The securities are divided into different tranches or classes, each with varying levels of risk and return. Senior tranches are typically less risky and offer lower returns, while junior tranches bear more risk and offer higher potential returns. Distribution: These securities are then sold to investors in the capital markets . Key Concepts in Structured Finance: Securitization: The process of converting illiquid assets into tradable securities. Tranching : Creating different classes of securities with varying risk and return profiles. Credit Enhancement: Techniques used to improve the credit quality of the securities, such as overcollateralization or credit guarantees. Special Purpose Vehicle (SPV): A legal entity created to hold the underlying assets and issue the securities.

3. Examples of Structured Finance Products: Mortgage-backed securities (MBS): Securities backed by a pool of mortgages. Asset-backed securities (ABS): Securities backed by a variety of assets, such as car loans, credit card receivables, or student loans. Collateralized debt obligations (CDOs): Securities backed by a pool of debt instruments, such as corporate bonds or other ABS . Benefits of Structured Finance: Increased liquidity: Converts illiquid assets into tradable securities. Risk diversification: Allows investors to diversify their portfolios across different asset classes. Credit enhancement: Improves the credit quality of the securities. Funding opportunities: Provides access to capital for issuers . Risks of Structured Finance: Credit risk: The risk of default on the underlying assets. Liquidity risk: The risk of not being able to easily sell the securities. Complexity: The complexity of structured finance products can make them difficult to understand and value. Systemic risk: In some cases, structured finance products can contribute to systemic risk in the financial system.

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