FRM Part II · FRM Exam Part II · Country Risk: Determinants, Measures, and Implications
A bank uses a sovereign rating-based approach to estimate country risk premiums. A Baa-rated country has a 10-year government bond yield of 7.5% in US dollars, while the US Treasury yield is 4.0%. Historical data show the default spread for Baa-rated sovereign bonds is 2.5%. What is the best interpretation of the 1.0% difference between the observed 3.5% yield spread and the 2.5% rating-based default spread?
The extra 1.0% (3.5% observed spread less the 2.5% rating-based spread) reflects the market pricing more risk, or demanding more compensation, than the rating's historical default spread implies. It is not currency risk, since the bond is denominated in dollars.
- AIt indicates the rating agency has made an error that must be corrected by upgrading the country
- BIt is a market-implied premium above the historical rating-based default spread, suggesting the market sees more risk than the rating implies or demands extra compensation for riskCorrect
- CIt is the country's currency risk premium, since the bond is in dollars
- DIt represents the equity risk premium differential between the two countries
Explanation
Observed spread 7.5% - 4.0% = 3.5%. Subtracting the 2.5% rating-based spread gives 1.0%. Because the bond is dollar-denominated, currency risk is not the cause. The gap reflects market-perceived additional risk or risk-premium demands beyond the rating's historical average.
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