A credit derivative (originally a collateralized debt obligation) whereby the credit risk on a reference portfolio is transferred between the counterparties. The reference portfolio is a bunch of credit default swaps (CDSs), the risk of loss on which is typically divided into tranches whose seniority is set in an increasing order. If losses occur, the tranches would be affected in a gradual order: first, equity tranche, then, mezzanine tranche, and finally, senior tranche. A particular tranche exposes collateralized debt obligation (CDO) investors to a specific level of credit risk. The investor, in effect, sells credit protection to the CDO issuer who in turn sells credit protection on the reference portfolio to hedge against risk. The sold protection on the reference portfolio takes the form of single-name credit default swaps.

Actually, the ultimate sellers of credit risk to investors engage the CDO issuer to intermediate the hedging transaction. Collateral in synthetic CDOs runs the gamut from investment-grade assets and high-yield assets to residential and commercial mortgage-backed securities (MBS), CDO tranches, and other forms of structured finance securities.