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

A bank's risk team wants to convert sovereign ratings into default spreads for a set of countries lacking traded bonds or liquid CDS. Which approach and limitation is most accurate?

The practical approach is to average market spreads on traded sovereign bonds or CDS within each rating class and apply that to countries without liquid instruments. The limitation is that spreads move with market conditions and vary within a class, so the mapping must be refreshed regularly.

  1. AAverage the yield spreads of traded sovereign bonds within each rating class, accepting that spreads are a noisy proxy that change with market conditions and must be updatedCorrect
  2. BUse the rating agency's published default spread, which is fixed and does not change over time
  3. CSet the spread equal to the country's inflation differential against the US
  4. DUse the historical frequency of ratings upgrades as the default spread

Explanation

The standard method assigns each rating class a default spread equal to the average spread on traded sovereign bonds or CDS of that class, then applies it to unrated or illiquid names. The spreads shift with market risk appetite, so the table needs periodic updating. Agencies do not publish fixed spreads, and inflation differentials measure a different risk.

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