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

A 10-year US dollar government bond issued by Country X yields 7.40%, while a 10-year US Treasury bond yields 4.20%. Both bonds are denominated in USD. Which of the following best describes the 3.20% difference when it is used as a measure of country default risk?

The 3.20% gap is the sovereign default spread. Because both bonds are in US dollars, currency and inflation differences are removed, so the yield difference over the Treasury reflects the market's compensation for the possibility that Country X defaults.

  1. AThe sovereign default spread implied by the bond marketCorrect
  2. BThe country's equity risk premium
  3. CThe expected depreciation of Country X's local currency
  4. DThe inflation differential between Country X and the United States

Explanation

When both bonds are denominated in the same currency (USD), the yield difference removes currency and inflation effects and approximates the default spread the market assigns to the sovereign. 7.40% - 4.20% = 3.20%. It is not an equity premium, which would require scaling by relative equity volatility.

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