,RSK4804 Assignment 2 (COMPLETE ANSWERS)
Semester 1 2025 – DUE 30 August 2025; 100% correct
solutions and explanations.
QUESTION 1
a. Why are credit default swaps (CDS) necessary? (2 marks)
Credit Default Swaps (CDS) are necessary for several reasons:
1. Credit Risk Protection:
CDS allow investors to hedge against credit risk—the risk
that a borrower will default on a debt obligation. By
purchasing CDS, an investor can transfer this risk to
another party.
2. Risk Management:
Financial institutions and investors use CDS to manage
portfolio credit exposure. It enables them to reduce risk
without having to sell off underlying assets.
3. Improves Liquidity in Credit Markets:
CDS promote liquidity by allowing credit risk to be traded
independently of the underlying bond. This provides
flexibility and market depth.
4. Price Discovery:
CDS spreads provide valuable information about the
perceived creditworthiness of borrowers. A higher spread
indicates higher perceived risk.
5. Enables Regulatory Capital Relief:
Banks may use CDS to reduce capital requirements, as
regulatory frameworks sometimes allow reduced capital if
the credit risk has been hedged.
, 6. Investment Opportunities:
CDS can also be used for speculative purposes—investors
can profit if they correctly anticipate changes in a
company’s creditworthiness, even if they don't own the
bond.
b. Why are some investors not in favour of credit default
swaps? (2 marks)
Despite their benefits, some investors are not in favour of CDS
for the following reasons:
1. Complexity and Lack of Transparency:
CDS contracts are complex financial instruments. The
lack of transparency in the over-the-counter (OTC) market
makes it difficult to assess risk.
2. Systemic Risk:
The 2008 Global Financial Crisis highlighted that
widespread CDS use can contribute to systemic risk—
defaults on CDS obligations can lead to cascading failures.
3. Speculative Use:
CDS are often used for speculation rather than hedging.
This can lead to market distortion and artificial increases
in credit risk perceptions.
4. Counterparty Risk:
There is always a risk that the CDS seller may default on
their obligation, especially in times of financial stress.
5. Moral Hazard:
Buyers of CDS may be incentivised to act against the
Semester 1 2025 – DUE 30 August 2025; 100% correct
solutions and explanations.
QUESTION 1
a. Why are credit default swaps (CDS) necessary? (2 marks)
Credit Default Swaps (CDS) are necessary for several reasons:
1. Credit Risk Protection:
CDS allow investors to hedge against credit risk—the risk
that a borrower will default on a debt obligation. By
purchasing CDS, an investor can transfer this risk to
another party.
2. Risk Management:
Financial institutions and investors use CDS to manage
portfolio credit exposure. It enables them to reduce risk
without having to sell off underlying assets.
3. Improves Liquidity in Credit Markets:
CDS promote liquidity by allowing credit risk to be traded
independently of the underlying bond. This provides
flexibility and market depth.
4. Price Discovery:
CDS spreads provide valuable information about the
perceived creditworthiness of borrowers. A higher spread
indicates higher perceived risk.
5. Enables Regulatory Capital Relief:
Banks may use CDS to reduce capital requirements, as
regulatory frameworks sometimes allow reduced capital if
the credit risk has been hedged.
, 6. Investment Opportunities:
CDS can also be used for speculative purposes—investors
can profit if they correctly anticipate changes in a
company’s creditworthiness, even if they don't own the
bond.
b. Why are some investors not in favour of credit default
swaps? (2 marks)
Despite their benefits, some investors are not in favour of CDS
for the following reasons:
1. Complexity and Lack of Transparency:
CDS contracts are complex financial instruments. The
lack of transparency in the over-the-counter (OTC) market
makes it difficult to assess risk.
2. Systemic Risk:
The 2008 Global Financial Crisis highlighted that
widespread CDS use can contribute to systemic risk—
defaults on CDS obligations can lead to cascading failures.
3. Speculative Use:
CDS are often used for speculation rather than hedging.
This can lead to market distortion and artificial increases
in credit risk perceptions.
4. Counterparty Risk:
There is always a risk that the CDS seller may default on
their obligation, especially in times of financial stress.
5. Moral Hazard:
Buyers of CDS may be incentivised to act against the
