Managing business finance Essay Example | Topics and Well Written Essays - 1750 words - 1

Managing business finance - Essay Example Usually banks engage in selling CLOs with different tranches that represent various ranks of seniority in terms of reward/risk profile (Duffie and Garleanu, 2001). CLO’s involve three key entities; banks, CLO managers, investors and borrowers. Now, in order to understand how CLO’s work it is important to explain the way in which securitisation works. At the very beginning a CLO manager approaches various investors in order to pull up funds from them and use them to buy loans (rather issue loans). These funds are pooled in one place sometimes also called as the securitisation vehicle which serves as the source of loans for potential borrowers. This vehicle generates interests every month which are paid back to the investors in terms of the riskiness assumed by them. There are various tranches of investments which are graded according to their risk/reward profile (Coval, Jurek and Stafford, 2009). Such as a AAA rated loan is less risk and less reward generating security whereas a BB rated loan is high risk high reward generating security. This means that when the securitisation vehicle generates interest every month, the investor a ssuming the exposure to a highly rated loan (less risky) is paid first but at the cost of a lower interest rate. On the other hand the investor assuming the exposure to a low rated loan (highly risky) is paid at the last but with a high interest rate. The fact here is that there is greater chance for the highly rated securities to pay out the return whereas there are lesser chances that the low rated investment tranches will generate a return (Antczak, Lucas and Fabozzi, 2011). Due to the demand for loans bank managers prefer to issue loans by pooling up funds from different sources in order to share the risk of default. They pool funds from their syndicates which involves (also termed as syndication) other banks, hedge funds and CLO managers. A loan is then divided into