,RSK4804 Assignment 2 2025 WELL ANSWERED
QUESTIONS Due 30 August 2025
RSK4804 – Assignment 2 (2025) Answer Guide
Due: 30 August 2025
Question 1: Credit Default Swaps (CDS)
(a) Why are CDS necessary? (2)
1. Unbundle and transfer credit risk: A CDS lets an investor
keep an asset’s interest-rate/cash-flow benefits while
hedging its default risk by buying protection on the same
reference entity.
2. Risk management flexibility & market completeness: CDS
provide customisable hedges (tenor, seniority) and
synthetic exposure (take a credit view without owning the
bond/loan). They also help manage concentration limits,
match risk appetite, and can lower regulatory capital when
used as eligible credit risk mitigation.
Other valid points you might add (briefly): price discovery for
credit risk, liquidity in otherwise illiquid credits, balance-sheet
management.
(b) Why are some investors not in favour of CDS? (2)
1. Systemic/opacity & counterparty risks: Complex
documentation, model dependence, and counterparty
, default risk (the protection seller might fail) can amplify
stress; “wrong-way risk” when the seller weakens as the
reference entity weakens.
2. Moral hazard & speculation concerns: “Naked” CDS can
invite speculative shorting of credit, possibly exacerbating
spread widening; the “empty-creditor” problem (hedged
lenders may be less willing to restructure). Also: basis risk
vs the actual asset, credit-event disputes, mark-to-market
volatility, and regulatory complexity.
(c) Case Analysis: Magong Rural Investments (MRI) & Moepi
Minerals Exploration (MME) (6)
Scenario (structure your answer like this, adapt to any
numbers the assignment gave you):
MRI holds a ZAR 100m, 5-year floating loan to MME at
JIBAR + 450 bps. MRI is concerned about commodity-cycle
risk.
MRI buys a 5-year CDS on MME from Bank X at a spread of
450 bps p.a. on ZAR 100m notional, assumed recovery
40% under 2014 ISDA definitions.
1) Objective & Hedge Design (1):
Objective: Hedge credit loss if MME defaults.
Instrument: Single-name CDS, Buyer = MRI, Seller = Bank
X, Notional matches loan outstanding, tenor aligned to
QUESTIONS Due 30 August 2025
RSK4804 – Assignment 2 (2025) Answer Guide
Due: 30 August 2025
Question 1: Credit Default Swaps (CDS)
(a) Why are CDS necessary? (2)
1. Unbundle and transfer credit risk: A CDS lets an investor
keep an asset’s interest-rate/cash-flow benefits while
hedging its default risk by buying protection on the same
reference entity.
2. Risk management flexibility & market completeness: CDS
provide customisable hedges (tenor, seniority) and
synthetic exposure (take a credit view without owning the
bond/loan). They also help manage concentration limits,
match risk appetite, and can lower regulatory capital when
used as eligible credit risk mitigation.
Other valid points you might add (briefly): price discovery for
credit risk, liquidity in otherwise illiquid credits, balance-sheet
management.
(b) Why are some investors not in favour of CDS? (2)
1. Systemic/opacity & counterparty risks: Complex
documentation, model dependence, and counterparty
, default risk (the protection seller might fail) can amplify
stress; “wrong-way risk” when the seller weakens as the
reference entity weakens.
2. Moral hazard & speculation concerns: “Naked” CDS can
invite speculative shorting of credit, possibly exacerbating
spread widening; the “empty-creditor” problem (hedged
lenders may be less willing to restructure). Also: basis risk
vs the actual asset, credit-event disputes, mark-to-market
volatility, and regulatory complexity.
(c) Case Analysis: Magong Rural Investments (MRI) & Moepi
Minerals Exploration (MME) (6)
Scenario (structure your answer like this, adapt to any
numbers the assignment gave you):
MRI holds a ZAR 100m, 5-year floating loan to MME at
JIBAR + 450 bps. MRI is concerned about commodity-cycle
risk.
MRI buys a 5-year CDS on MME from Bank X at a spread of
450 bps p.a. on ZAR 100m notional, assumed recovery
40% under 2014 ISDA definitions.
1) Objective & Hedge Design (1):
Objective: Hedge credit loss if MME defaults.
Instrument: Single-name CDS, Buyer = MRI, Seller = Bank
X, Notional matches loan outstanding, tenor aligned to
