RSK4804 Assignment 2 2025 (Answer Guide) - Due 30 August 2025

RSK4804 Assignment 2 2025 (Answer Guide) - Due 30 August 2025 Question 1: Credit Default Swaps (a) Why are credit default swaps (CDS) necessary? (2 marks) Credit default swaps (CDS) are essential financial instruments used primarily for credit risk management. They allow investors or lenders to transfer the credit risk of a borrower or debt instrument to another party in exchange for a premium. In simple terms, a CDS works like insurance against a borrower defaulting on a loan or bond. For instance, if a company or government entity defaults on its obligations, the seller of the CDS compensates the buyer for the loss (Hull, 2018). CDS instruments provide credit protection, allowing investors to manage their exposure to potential defaults without having to sell the underlying asset. This flexibility is especially important in volatile markets, where selling assets might not be feasible or desirable. (b) Why are some investors not in favour of credit default swaps? (2 marks) Despite their usefulness, some investors are critical of CDS due to the systemic risks and speculative behaviour they may encourage. One major concern is that CDS can be used for speculation rather than genuine risk protection. Investors who do not own the underlying debt can still buy CDS contracts, effectively betting that a company will default a practice known as a "naked CDS". This can amplify market stress and lead to artificial downward pressure on the value of debt instruments (Mishkin & Eakins, 2019). Furthermore, during the 2008 Global Financial Crisis, the interconnectedness of CDS contracts contributed to the collapse of major institutions, as many firms were exposed to unmanageable risks they had underwritten through CDS, with insufficient reserves to pay out in the event of widespread d