FRM Exam Part II · Country Risk: Determinants, Measures, and Implications

Sovereign Ratings and Rating Agencies: Methodology and Limitations

Updated 11 October 2026 · Fact-checked

A sovereign rating is an agency's opinion of a government's ability and willingness to repay its debt. Agencies such as Moody's and S&P combine economic, fiscal, external, institutional and political factors into a letter grade. For the exam, know the factors, the local vs foreign currency split, and the biases: lag, procyclicality and herding.

Understand Sovereign Ratings and Rating Agencies

A sovereign rating is a letter grade that ranks a government's default risk. S&P and Fitch use AAA down to D. Moody's uses Aaa down to C. Ratings at BBB- (S&P/Fitch) or Baa3 (Moody's) and above are investment grade. Anything lower is speculative grade (high yield).

Agencies do not use one formula. They score a set of factors and then apply analyst judgement. Typical factors are: economic strength and growth prospects, institutional strength and governance, fiscal strength (deficits, debt level, debt affordability), external position (current account, reserves, external debt), monetary flexibility, and event or political risk. A committee votes on the final rating. The rating may also carry an outlook (positive, stable, negative) that signals the likely direction over the next 1-2 years.

Agencies usually publish two ratings for a sovereign. The local currency rating covers debt issued in the government's own currency. The foreign currency rating covers debt issued in other currencies, such as USD or EUR. A government can print its own currency, so local currency default is less likely. That is why the local currency rating is usually equal to or higher than the foreign currency rating. A sovereign with a floating exchange rate and its own central bank is more likely to have a local currency rating above its foreign currency rating. Where a country has given up its currency (a euro member), there is no such gap.

Sovereign ratings matter because they act as a ceiling or anchor for other ratings. Banks and companies in a country often get rated at or below the sovereign. Some investors and regulations also depend on ratings, so a downgrade across the investment-grade line can force selling.

Ratings have known weaknesses. They are lagging: they often move after markets have already repriced the risk. They tend to be procyclical: upgrades in booms and sharp downgrades in crises. They are ordinal, not a precise default probability. Agencies may also face conflicts of interest, since issuers pay for ratings. Market measures such as sovereign CDS spreads and bond yields usually react faster and often imply a different rating than the agencies have assigned.

Key formulas to remember

Investment-grade boundary: Investment grade: S&P/Fitch ≥ BBB-; Moody's ≥ Baa3; One notch lower is speculative grade. Crossing this line is a major event.
Local vs foreign currency ordering: Local currency rating ≥ Foreign currency rating (typically); A usual pattern, not a law. Reason: a government can create its own currency but not USD or EUR.
Market-implied rating spread idea: Spread gap = Market spread − Spread typical for the agency rating; A market spread far above the rating's typical level signals the market sees more risk than the agency does.

How to solve Sovereign Ratings and Rating Agencies questions

Use this approach for any question on sovereign ratings, whether it is about methodology, currency splits or limitations.

1Identify what is being asked: methodology factor, local vs foreign currency, interpretation of a rating or outlook, or limitation of ratings.
2If a rating is given, place it on the scale and decide whether it is investment grade or speculative grade.
3For methodology questions, map each fact in the case to a factor: economic, institutional, fiscal, external, monetary or political.
4For currency questions, ask who can create the currency the debt is issued in. Own currency means lower default risk, so a higher rating.
5For limitation questions, match the symptom to the bias: late move means lag, downgrades in a crisis means procyclicality, issuer-pays means conflict of interest.
6Compare agency ratings with market evidence (CDS spreads, yields) if the question gives it, and state which is more timely.
7Pick the option that uses the exact concept and does not overstate it (for example, 'usually' not 'always').

Quickest way: Three-question shortcut

When to use it: Use when you have under a minute and the options look similar.

Ask: is this about which factor, which currency, or which weakness?
Currency of debt decides the rating gap: own currency is safer than foreign currency.
Weakness keywords: 'after the crisis began' means lag; 'amplifies downturn' means procyclical; 'issuer pays' means conflict.
Eliminate absolute statements such as 'ratings always predict default'.

Common mistakes in Sovereign Ratings and Rating Agencies

Saying the foreign currency rating is usually higher than the local currency rating.
Students think foreign currency debt is more secure because it is a hard currency.
Fix: Remember the sovereign can print local currency but not USD or EUR. Local currency rating is usually equal or higher.
Treating a rating as a precise default probability.
Letter grades are linked in memory to historical default tables.
Fix: A rating is an ordinal opinion. Historical default rates by grade are averages and vary over time.
Believing agencies use a fixed mathematical formula.
Questions about 'rating models' suggest a quantitative equation.
Fix: Agencies score factors but use committee judgement. Say 'scorecard plus judgement'.
Confusing the outlook with a rating change.
Both signal direction.
Fix: An outlook is a view on the likely direction over the medium term. The rating itself has not changed.
Thinking ratings lead markets.
Students assume agencies have superior information.
Fix: Evidence shows markets and CDS spreads often move before downgrades. Ratings lag and tend to be procyclical.

Worked examples

Example 1

A country borrows heavily in USD but has a floating currency and its own central bank. It issues debt in both its own currency and USD. An agency rates the local currency debt A and the USD debt BBB+. Explain the gap and say whether the foreign currency debt is investment grade (S&P scale).

Show the solution

The local currency debt is rated higher: A is above BBB+.
Reason for the gap: the government can create its own currency to service local debt, so default risk is lower.
The government cannot create USD. It must earn or borrow them, so it faces external and reserve constraints.
BBB+ is above the BBB- boundary, so the USD debt is still investment grade.

Answer: The two-notch gap (A vs BBB+) reflects the government's ability to print local currency but not USD. The USD debt, at BBB+, is investment grade.

Example 2

During a crisis a sovereign's CDS spread widens sharply for months. Only afterwards does an agency downgrade it by several notches, and the downgrade deepens the sell-off. Which two limitations of sovereign ratings does this show, and what does the CDS market add?

Show the solution

The downgrade came after the market had already repriced risk. This is the lag (rating stickiness) limitation.
The downgrade then worsened the sell-off, because investors with rating-based rules had to sell. This shows procyclicality.
The CDS spread moved first, so it reflects market information faster than the agency rating.
CDS can therefore be used as a timely cross-check on the rating.

Answer: The episode shows ratings lag the market and are procyclical. The CDS spread gave an earlier signal and is a useful complement to the rating.

Exam tips

Expect case-style questions: match facts to factors (fiscal, external, institutional, political).
Learn the direction of the local vs foreign currency gap and its reason, and be ready for the exception of a country that has no own currency.
Watch for absolute words such as 'always' and 'never'. Rating rules are tendencies.
Know the investment-grade cut-off on both Moody's and S&P scales.
When market data are given, use them to judge whether the rating is stale.

Practice questions from Country Risk: Determinants, Measures, and Implications

Sovereign Ratings and Rating Agencies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Sovereign Ratings and Rating Agencies: frequently asked questions

How do rating agencies rate countries?

They assess factors such as economic strength, institutions, fiscal position, external position, monetary flexibility and political risk. Analysts score these and a rating committee decides the final grade. Judgement matters as much as the scores.

What is the difference between local currency and foreign currency sovereign ratings?

The local currency rating covers debt in the government's own currency. The foreign currency rating covers debt in other currencies like USD or EUR. The local rating is usually equal or higher because the government can create its own currency.

What are the limitations of sovereign ratings?

They lag market information, tend to be procyclical, are ordinal rather than exact default probabilities, and may involve conflicts of interest because issuers pay. Herding among agencies can also add to the problem.

Is a sovereign rating the same as a sovereign default probability?

No. A rating is a ranking opinion. Historical default rates for each grade can be used as rough guidance, but they change over time and across cycles.