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Collateralized Debt Obligation
An asset-backed security backed by the receivables on loans, bonds, or other debt. Banks package and sell their receivables on debt to investors in order to reduce the risk of loss due to default. Returns on CDOs are paid in tranches; that is, the individual loans backing each CDO have different levels of risk, and investors are paid out according to the level of risk they have acquired. Banks offer higher interest rates to investors willing to buy CDOs backed by higher-risk loans. From a bank's perspective, in addition to reducing risk, CDOs also reduce their capital requirements because they can raise funds through the issue of CDOs. While, theoretically, CDOs can be backed by mortgages, one usually refers to these as collateralized mortgage obligations.