, PLEASE USE THIS DOCUMENT AS A GUIDE TO ANSWER YOUR ASSIGNMENT
Question 1
1. In recent years, there has been quite a buzz about credit default swaps. The turn of events
following the 2008 Global Financial Crisis became a test of the systems that settle credit default
swaps.
a. Why are credit default swaps (CDS) necessary?
Credit Default Swaps (CDS) are essential for managing and transferring credit risk. They allow
investors to hedge against potential defaults, providing a form of financial protection for lenders and
bondholders. By offering insurance against borrower defaults, CDS help mitigate losses, optimize
portfolios, and improve market efficiency. They also enable financial institutions to reduce credit
exposure, enhance lending capacity, and manage complex risks more effectively. Ultimately, CDS
support better risk management and financial stability within the credit markets.
b. Why are some investors not in favour of credit default swaps?
Some investors are wary of credit default swaps (CDS) due to concerns about market inefficiency
and transparency. The lack of adequate infrastructure and manual processing increases operational
risks. Additionally, the structural complexity of CDS and related products like CDOs can sometimes
fail to mitigate risk effectively. Limited liquidity and the potential for contagion from correlated
assets add to concerns about systemic risk. Furthermore, the over-the-counter (OTC) nature of CDS
reduces market transparency and increases uncertainty about their true impact.
c. Magong Rural Investments has invested R80m in bonds issued by Moepi Minerals
Exploration. Magong Rural Investments has noted that Moepi Minerals Exploration may be
experiencing financial difficulties. Therefore, Magong Platinum Project buys R80 m worth of
CDS protection on Moepi Minerals Exploration debt, for three years, from the Sedibelo
Development Bank, at a premium of 250 bps (2.5%) per annum. Explain the scenarios of default
and no default.
Scenario 1: No Default by Moepi Minerals Exploration
If Moepi Minerals Exploration does not default on its debt during the three-year term:
Premium Payments Continue: Magong Platinum Project will continue to pay the annual
premium of 2.5% of the R80 million, amounting to R2 million each year. Over three years,
Magong will have paid a total of R6 million in premiums.
No Compensation: Since no default occurs, Sedibelo Development Bank will not make any
compensation payment to Magong Platinum Project.
Contract Expiration: After three years, the CDS contract expires, and Sedibelo Development
Bank will retain the premiums as compensation for assuming the default risk, which never
materialized.
Question 1
1. In recent years, there has been quite a buzz about credit default swaps. The turn of events
following the 2008 Global Financial Crisis became a test of the systems that settle credit default
swaps.
a. Why are credit default swaps (CDS) necessary?
Credit Default Swaps (CDS) are essential for managing and transferring credit risk. They allow
investors to hedge against potential defaults, providing a form of financial protection for lenders and
bondholders. By offering insurance against borrower defaults, CDS help mitigate losses, optimize
portfolios, and improve market efficiency. They also enable financial institutions to reduce credit
exposure, enhance lending capacity, and manage complex risks more effectively. Ultimately, CDS
support better risk management and financial stability within the credit markets.
b. Why are some investors not in favour of credit default swaps?
Some investors are wary of credit default swaps (CDS) due to concerns about market inefficiency
and transparency. The lack of adequate infrastructure and manual processing increases operational
risks. Additionally, the structural complexity of CDS and related products like CDOs can sometimes
fail to mitigate risk effectively. Limited liquidity and the potential for contagion from correlated
assets add to concerns about systemic risk. Furthermore, the over-the-counter (OTC) nature of CDS
reduces market transparency and increases uncertainty about their true impact.
c. Magong Rural Investments has invested R80m in bonds issued by Moepi Minerals
Exploration. Magong Rural Investments has noted that Moepi Minerals Exploration may be
experiencing financial difficulties. Therefore, Magong Platinum Project buys R80 m worth of
CDS protection on Moepi Minerals Exploration debt, for three years, from the Sedibelo
Development Bank, at a premium of 250 bps (2.5%) per annum. Explain the scenarios of default
and no default.
Scenario 1: No Default by Moepi Minerals Exploration
If Moepi Minerals Exploration does not default on its debt during the three-year term:
Premium Payments Continue: Magong Platinum Project will continue to pay the annual
premium of 2.5% of the R80 million, amounting to R2 million each year. Over three years,
Magong will have paid a total of R6 million in premiums.
No Compensation: Since no default occurs, Sedibelo Development Bank will not make any
compensation payment to Magong Platinum Project.
Contract Expiration: After three years, the CDS contract expires, and Sedibelo Development
Bank will retain the premiums as compensation for assuming the default risk, which never
materialized.
