What are collateralized debt obligations (CDOs) primarily composed of?

Collateralized debt obligations (CDOs) are primarily composed of a mix of loans or other assets. CDOs are structured financial products that bundle together different types of debt instruments, such as mortgages, corporate bonds, or other forms of loans. The key feature of these derivatives is the pooling of various debt obligations, which are then divided into tranches with varying risk levels and yields. This structure allows investors to gain exposure to the cash flows from the underlying assets while distributing risk among different securities.

The composition of a CDO helps to diversify risk, as they typically include a variety of assets with different credit qualities, thereby providing a more stable return to investors. The importance of having a diverse mixture of loans or assets in a CDO is crucial for enhancing the risk and return profile of the investment, making it appealing to various types of investors with different risk appetites.

Other options provided do not capture the essence of CDOs since they either limit the assets included (like only government-backed securities or a single type of loan) or involve entirely different types of financial instruments (such as stocks). This shows that understanding the fundamental structure and function of CDOs is essential in grasping their role in financial markets.