The CDO Framework for Hedge-Fund-Linked Principal-Protected Securities

Abstract

Principal-protected securities linked to hedge funds are a popular form of investment vehicle. The principal amount of these securities is guaranteed at maturity by a financial institution. The financial institution covers its exposure under the guarantee by utilizing either a static or dynamic hedging methodology. The dynamic hedging is based on constant proportion portfolio insurance (“CPPI”) technology pioneered by André Perold of Harvard, and simultaneously by Fischer Black and Robert Jones of Goldman Sachs in 1986. In this article, the author provides a framework for structuring principal-protected securities transactions based on collateralized debt obligation (“CDO”) technology. The CDO framework obviates the need for a financial institution to guarantee the principal amount of the securities, enhances the economic efficiency of the securities, provides structural transparency, and broadens market participation in the securities. The author believes that the framework described in the article would be valuable for fixed-income CDO professionals and equity derivative professionals in creating principal-protected securities in areas of their structured products transactions.