Credit arbitrage is similar to capital structure arbitrage, and may also seek to take advantage of pricing inefficiencies between the credit-sensitive securities of different issuers. Instruments commonly traded include CDOs and CDSs. A CDO (Collateralized Debt Obligation) is an investment vehicle that raises capital through the issuance of shares and debt and uses the proceeds to purchase financial assets, such as leveraged loans, bonds and other debt instruments. CDOs are designed to reallocate the credit risk of the underlying asset portfolio among different tranches, passing through the risk of the portfolio on a tiered basis to investors. The CDO portfolio, comprising perhaps hundreds of individual securities, is well diversified with respect to issuer, industry, and sector. A credit default swap (CDS) is a derivative contract that typically requires the seller to pay to the buyer, in the event that a particular reference entity experiences specified credit events, the difference between the notional amount of the contract and the value of a portfolio of securities issued by the reference entity that the buyer delivers to the seller. In return, the buyer agrees to make periodic payments equal to a fixed percentage of the notional amount of the contract.
