RSK4804 Assignment 2
(COMPLETE ANSWERS)
2025 - DUE 30 August 2025
For assistance contact
Email:
, Question 1
a. Why are credit default swaps (CDS) necessary? (2)
Credit default swaps (CDS) are necessary because they act as a form of insurance for creditors.
They allow a lender (or bondholder) to hedge against the risk of a borrower defaulting on their
debt obligations. The CDS buyer pays a regular premium to the CDS seller in exchange for a
payout if a specified credit event (like a bankruptcy or failure to pay) occurs. This allows
investors to manage and transfer credit risk without selling the underlying asset.
b. Why are some investors not in favour of credit default swaps? (2)
Some investors are not in favor of credit default swaps for several reasons:
Moral Hazard: CDS can encourage risky lending practices. A lender who has purchased
a CDS may be less diligent in their due diligence, knowing that their risk is insured.
Systemic Risk: The opaqueness and interconnectedness of the CDS market can lead to
systemic risk. As seen in the 2008 financial crisis, the failure of a large CDS seller (like
AIG) can have a cascading effect across the entire financial system.
Speculation: Many investors use CDS for speculative purposes rather than for hedging.
They might buy a CDS on a company they believe will fail, without owning the
underlying debt. This can contribute to market instability and be seen as a form of betting
against a company's success.
c. Magong Rural Investments and Moepi Minerals Exploration (6)
No Default Scenario:
Premium Payment: Magong Rural Investments (MRI) will pay Sedibelo Development
Bank (SDB) a premium of 2.5% on the R80m notional value each year for three years.
Annual Premium: R80,000,000×0.025=R2,000,000
Total Premium: R2,000,000×3=R6,000,000
Outcome: At the end of the three years, Moepi Minerals Exploration (MME)
successfully repays its bonds. The CDS expires, and SDB keeps the R6 million in
premium payments. MRI has spent R6 million for protection that was not needed, but it
was protected against the risk of default.
Default Scenario:
Premium Payment: MRI continues to pay the premium to SDB up until the point of
default. For example, if MME defaults after two years, MRI would have paid premiums
for two years, totaling R2,000,000×2=R4,000,000.
Credit Event: MME experiences a credit event (e.g., bankruptcy or failure to pay).
(COMPLETE ANSWERS)
2025 - DUE 30 August 2025
For assistance contact
Email:
, Question 1
a. Why are credit default swaps (CDS) necessary? (2)
Credit default swaps (CDS) are necessary because they act as a form of insurance for creditors.
They allow a lender (or bondholder) to hedge against the risk of a borrower defaulting on their
debt obligations. The CDS buyer pays a regular premium to the CDS seller in exchange for a
payout if a specified credit event (like a bankruptcy or failure to pay) occurs. This allows
investors to manage and transfer credit risk without selling the underlying asset.
b. Why are some investors not in favour of credit default swaps? (2)
Some investors are not in favor of credit default swaps for several reasons:
Moral Hazard: CDS can encourage risky lending practices. A lender who has purchased
a CDS may be less diligent in their due diligence, knowing that their risk is insured.
Systemic Risk: The opaqueness and interconnectedness of the CDS market can lead to
systemic risk. As seen in the 2008 financial crisis, the failure of a large CDS seller (like
AIG) can have a cascading effect across the entire financial system.
Speculation: Many investors use CDS for speculative purposes rather than for hedging.
They might buy a CDS on a company they believe will fail, without owning the
underlying debt. This can contribute to market instability and be seen as a form of betting
against a company's success.
c. Magong Rural Investments and Moepi Minerals Exploration (6)
No Default Scenario:
Premium Payment: Magong Rural Investments (MRI) will pay Sedibelo Development
Bank (SDB) a premium of 2.5% on the R80m notional value each year for three years.
Annual Premium: R80,000,000×0.025=R2,000,000
Total Premium: R2,000,000×3=R6,000,000
Outcome: At the end of the three years, Moepi Minerals Exploration (MME)
successfully repays its bonds. The CDS expires, and SDB keeps the R6 million in
premium payments. MRI has spent R6 million for protection that was not needed, but it
was protected against the risk of default.
Default Scenario:
Premium Payment: MRI continues to pay the premium to SDB up until the point of
default. For example, if MME defaults after two years, MRI would have paid premiums
for two years, totaling R2,000,000×2=R4,000,000.
Credit Event: MME experiences a credit event (e.g., bankruptcy or failure to pay).
