,RSK4804 Assignment 2 (COMPLETE ANSWERS)
Semester 1 2025 – DUE 30 August 2025; 100%
TRUSTED Complete trusted solutions and
explanations.
Question 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? (2)
1. Risk Transfer: CDS allows bondholders or lenders to transfer the
credit risk of a borrower defaulting to another party (the CDS
seller), offering protection against potential losses.
2. Credit Risk Management: Financial institutions use CDS to
manage and hedge their credit exposure, especially in volatile or
uncertain markets.
3. Pricing and Information Discovery: CDS spreads provide
market-based estimates of a company's creditworthiness, which
can supplement or even outperform traditional credit ratings.
4. Liquidity Enhancement: CDS markets offer an alternative for
investors to gain or reduce exposure to a borrower’s credit risk
without directly buying or selling the underlying debt instrument.
5. Investment Tool: Some investors use CDS to speculate on
changes in credit quality or to arbitrage between bond and CDS
markets.
, b. Why are some investors not in favour of credit default
swaps? (2)
Lack of Transparency: CDS contracts are over-the-counter (OTC)
instruments, making it difficult to assess the total exposure or
concentration of risk in the financial system.
Counterparty Risk: The CDS buyer depends on the seller’s ability to
pay in the event of default; if the seller defaults, protection fails.
Moral Hazard and Speculation: Investors can buy CDS without
owning the underlying bond (naked CDS), which may incentivize
speculative behavior rather than risk protection.
Systemic Risk Amplification: The 2008 crisis revealed how CDS
interconnectedness could spread risk across institutions, magnifying
financial instability.
Mispricing of Risk: Market participants might misinterpret CDS
spreads, leading to either complacency or panic, both of which can
distort credit assessments.
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
Semester 1 2025 – DUE 30 August 2025; 100%
TRUSTED Complete trusted solutions and
explanations.
Question 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? (2)
1. Risk Transfer: CDS allows bondholders or lenders to transfer the
credit risk of a borrower defaulting to another party (the CDS
seller), offering protection against potential losses.
2. Credit Risk Management: Financial institutions use CDS to
manage and hedge their credit exposure, especially in volatile or
uncertain markets.
3. Pricing and Information Discovery: CDS spreads provide
market-based estimates of a company's creditworthiness, which
can supplement or even outperform traditional credit ratings.
4. Liquidity Enhancement: CDS markets offer an alternative for
investors to gain or reduce exposure to a borrower’s credit risk
without directly buying or selling the underlying debt instrument.
5. Investment Tool: Some investors use CDS to speculate on
changes in credit quality or to arbitrage between bond and CDS
markets.
, b. Why are some investors not in favour of credit default
swaps? (2)
Lack of Transparency: CDS contracts are over-the-counter (OTC)
instruments, making it difficult to assess the total exposure or
concentration of risk in the financial system.
Counterparty Risk: The CDS buyer depends on the seller’s ability to
pay in the event of default; if the seller defaults, protection fails.
Moral Hazard and Speculation: Investors can buy CDS without
owning the underlying bond (naked CDS), which may incentivize
speculative behavior rather than risk protection.
Systemic Risk Amplification: The 2008 crisis revealed how CDS
interconnectedness could spread risk across institutions, magnifying
financial instability.
Mispricing of Risk: Market participants might misinterpret CDS
spreads, leading to either complacency or panic, both of which can
distort credit assessments.
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
