, RSK4804 Assignment 2 Memo
Due: 30 August 2025
Question 1 [10]
a. Why are credit default swaps (CDS) necessary? (2)
Credit default swaps (CDS) are essential instruments in modern financial markets
because they offer a mechanism to transfer and manage credit risk. They allow a
party exposed to the risk of default on a debt instrument—such as a corporate
bond—to purchase protection from another party in exchange for a premium. This
contractual arrangement ensures that, in the event of a credit event such as default,
restructuring, or bankruptcy of the reference entity, the protection buyer receives
compensation for the loss. CDSs play a key role in enhancing market liquidity,
enabling credit risk diversification, and fostering investor confidence, particularly in
volatile markets. Moreover, they contribute to price discovery in the credit markets
and can serve as leading indicators of credit deterioration.
b. Why are some investors not in favour of credit default swaps? (2)
Despite their utility, credit default swaps are controversial, and many investors are
cautious or outright critical of them. One major concern is the speculative use of
CDSs by parties who do not hold the underlying credit asset, which can lead to
"naked CDS" positions. These positions can artificially inflate the perceived credit risk
of a company or government, leading to increased volatility and, in some cases,
contributing to self-fulfilling defaults. Additionally, during the 2008 Global Financial
Crisis, the CDS market was exposed as being poorly regulated and opaque, with
many contracts traded over-the-counter without central clearing. This lack of
transparency and standardisation increased systemic risk, as parties were often
unaware of the exposure levels of their counterparties. The failure of major
institutions like AIG, which had sold large volumes of CDS protection without
sufficient capital backing, underscored these risks and led to calls for greater
regulation and reform in the derivatives market.
c. Magong Rural Investments Scenario: Default vs. No Default (6)
Magong Rural Investments has purchased bonds worth R80 million issued by Moepi
Minerals Exploration and, in response to indications of potential financial distress,
decides to hedge its exposure by buying credit default swap protection from Sedibelo
Development Bank. The CDS contract spans three years, with a premium of 250 basis
points annually, equating to a payment of R2 million per year.
In the event of a default, Moepi Minerals Exploration would fail to meet its debt
obligations during the contract period. Sedibelo Development Bank, as the CDS
Due: 30 August 2025
Question 1 [10]
a. Why are credit default swaps (CDS) necessary? (2)
Credit default swaps (CDS) are essential instruments in modern financial markets
because they offer a mechanism to transfer and manage credit risk. They allow a
party exposed to the risk of default on a debt instrument—such as a corporate
bond—to purchase protection from another party in exchange for a premium. This
contractual arrangement ensures that, in the event of a credit event such as default,
restructuring, or bankruptcy of the reference entity, the protection buyer receives
compensation for the loss. CDSs play a key role in enhancing market liquidity,
enabling credit risk diversification, and fostering investor confidence, particularly in
volatile markets. Moreover, they contribute to price discovery in the credit markets
and can serve as leading indicators of credit deterioration.
b. Why are some investors not in favour of credit default swaps? (2)
Despite their utility, credit default swaps are controversial, and many investors are
cautious or outright critical of them. One major concern is the speculative use of
CDSs by parties who do not hold the underlying credit asset, which can lead to
"naked CDS" positions. These positions can artificially inflate the perceived credit risk
of a company or government, leading to increased volatility and, in some cases,
contributing to self-fulfilling defaults. Additionally, during the 2008 Global Financial
Crisis, the CDS market was exposed as being poorly regulated and opaque, with
many contracts traded over-the-counter without central clearing. This lack of
transparency and standardisation increased systemic risk, as parties were often
unaware of the exposure levels of their counterparties. The failure of major
institutions like AIG, which had sold large volumes of CDS protection without
sufficient capital backing, underscored these risks and led to calls for greater
regulation and reform in the derivatives market.
c. Magong Rural Investments Scenario: Default vs. No Default (6)
Magong Rural Investments has purchased bonds worth R80 million issued by Moepi
Minerals Exploration and, in response to indications of potential financial distress,
decides to hedge its exposure by buying credit default swap protection from Sedibelo
Development Bank. The CDS contract spans three years, with a premium of 250 basis
points annually, equating to a payment of R2 million per year.
In the event of a default, Moepi Minerals Exploration would fail to meet its debt
obligations during the contract period. Sedibelo Development Bank, as the CDS
