RSK4804
Assignment 2
Unique No: 865771
Due 30 August 2025
, RSK4804
Assignment 2
Unique number 865771
Due date: 30 August 2025
Comprehensive Solution and Interpretation
Credit Risk Management
Question 1: Credit Default Swaps (CDS)
a. Necessity of Credit Default Swaps
Credit Default Swaps (CDS) serve as essential financial instruments for transferring credit
risk. Their primary function lies in providing insurance-like protection against the default
of a borrower. Through CDS contracts, the buyer of protection transfers the credit risk
associated with a specific debt instrument, such as a bond or loan, to the seller of the swap.
This mechanism is critical for investors and financial institutions seeking to manage and
hedge credit exposures, particularly in volatile markets [1].
CDS enhance market liquidity by enabling participants to express views on credit risk
without necessarily holding the underlying assets. Furthermore, they allow for price
discovery in the credit market, assisting in the valuation of credit instruments.
b. Investor Concerns Regarding CDS
Despite their benefits, some investors remain skeptical about CDS. First, these instruments
may lead to moral hazard, where lenders engage in riskier lending practices, knowing they
are protected through CDS. Second, the complexity and opacity surrounding CDS contracts
can obscure true risk exposure, as witnessed during the 2008 Global Financial Crisis [2]. In
such instances, the interconnectedness of counterparties in CDS markets heightened
systemic risk, leading to significant market instability.
Assignment 2
Unique No: 865771
Due 30 August 2025
, RSK4804
Assignment 2
Unique number 865771
Due date: 30 August 2025
Comprehensive Solution and Interpretation
Credit Risk Management
Question 1: Credit Default Swaps (CDS)
a. Necessity of Credit Default Swaps
Credit Default Swaps (CDS) serve as essential financial instruments for transferring credit
risk. Their primary function lies in providing insurance-like protection against the default
of a borrower. Through CDS contracts, the buyer of protection transfers the credit risk
associated with a specific debt instrument, such as a bond or loan, to the seller of the swap.
This mechanism is critical for investors and financial institutions seeking to manage and
hedge credit exposures, particularly in volatile markets [1].
CDS enhance market liquidity by enabling participants to express views on credit risk
without necessarily holding the underlying assets. Furthermore, they allow for price
discovery in the credit market, assisting in the valuation of credit instruments.
b. Investor Concerns Regarding CDS
Despite their benefits, some investors remain skeptical about CDS. First, these instruments
may lead to moral hazard, where lenders engage in riskier lending practices, knowing they
are protected through CDS. Second, the complexity and opacity surrounding CDS contracts
can obscure true risk exposure, as witnessed during the 2008 Global Financial Crisis [2]. In
such instances, the interconnectedness of counterparties in CDS markets heightened
systemic risk, leading to significant market instability.
