RSK4804
Assignment 2
Unique No: 865771
Due 30 August_2025
, RSK4804 Assignment 2 – Question 1 [10 Marks]
a. Purpose of Credit Default Swaps (CDS)
Credit default swaps (CDS) are financial instruments used to manage credit risk. They
act as insurance contracts by allowing investors to transfer the credit risk of a third party
to another entity. The primary function of a CDS is to protect the buyer against potential
losses resulting from the default of a borrower, such as a corporation or government.
This enhances market efficiency by promoting risk sharing, supporting liquidity, and
aiding price formation in credit markets (Hull, 2018).
b. Concerns Regarding Credit Default Swaps
Certain investors oppose the use of CDS for several reasons:
1. CDS may increase overall financial system risk, especially during crises, as
witnessed in 2008.
2. They can be misused for speculative trading, where investors profit from defaults
without holding the actual credit asset.
3. The over-the-counter nature of many CDS transactions creates transparency
issues and exposes markets to counterparty risk, potentially destabilizing
financial institutions (Stulz, 2010).
c. Scenario: Magong Rural Investments and Moepi Minerals Exploration
• If Moepi Defaults:
Should Moepi Minerals Exploration default on its bond commitments, Sedibelo
Development Bank (as the CDS provider) is obligated to reimburse Magong
Platinum Project (the CDS holder) for the shortfall between the bond's face value
and the recovery amount. This ensures that Magong's financial loss is mitigated.
• If No Default Occurs:
If Moepi Minerals meets its bond obligations over the three-year term, Magong
Platinum Project will continue paying a CDS premium of 2.5% annually on the
R80 million bond. This amounts to R2 million per year, totaling R6 million across
Assignment 2
Unique No: 865771
Due 30 August_2025
, RSK4804 Assignment 2 – Question 1 [10 Marks]
a. Purpose of Credit Default Swaps (CDS)
Credit default swaps (CDS) are financial instruments used to manage credit risk. They
act as insurance contracts by allowing investors to transfer the credit risk of a third party
to another entity. The primary function of a CDS is to protect the buyer against potential
losses resulting from the default of a borrower, such as a corporation or government.
This enhances market efficiency by promoting risk sharing, supporting liquidity, and
aiding price formation in credit markets (Hull, 2018).
b. Concerns Regarding Credit Default Swaps
Certain investors oppose the use of CDS for several reasons:
1. CDS may increase overall financial system risk, especially during crises, as
witnessed in 2008.
2. They can be misused for speculative trading, where investors profit from defaults
without holding the actual credit asset.
3. The over-the-counter nature of many CDS transactions creates transparency
issues and exposes markets to counterparty risk, potentially destabilizing
financial institutions (Stulz, 2010).
c. Scenario: Magong Rural Investments and Moepi Minerals Exploration
• If Moepi Defaults:
Should Moepi Minerals Exploration default on its bond commitments, Sedibelo
Development Bank (as the CDS provider) is obligated to reimburse Magong
Platinum Project (the CDS holder) for the shortfall between the bond's face value
and the recovery amount. This ensures that Magong's financial loss is mitigated.
• If No Default Occurs:
If Moepi Minerals meets its bond obligations over the three-year term, Magong
Platinum Project will continue paying a CDS premium of 2.5% annually on the
R80 million bond. This amounts to R2 million per year, totaling R6 million across
