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

A corporate treasurer notes that a sovereign downgrade often leads to downgrades of domestic companies in that country. Which explanation best describes why corporate exposure is linked to sovereign risk, in the context of country risk implications?

Sovereign distress hurts domestic firms through channels such as capital controls, higher taxes, currency crises and weaker domestic demand, which reduce their ability to service debt. This is why corporate credit quality tends to fall with sovereign downgrades, even though the link is not a legal rule or identical default probability.

  1. ACompanies cannot be rated above their domestic sovereign under any circumstances, since sovereign ratings are legally binding on firms
  2. BSovereign distress can bring capital controls, higher taxes, currency crises and weaker domestic demand, which harm firms' ability to service debtCorrect
  3. CSovereign downgrades raise the global equity risk premium by an equal amount for all firms
  4. DCompanies and sovereigns share identical default probabilities

Explanation

Sovereign stress transmits to firms through capital controls, taxation, currency depreciation, and weak economic conditions, so firms' credit quality tends to fall. The legal-binding claim is false; ratings ceilings are a practice, not a law, and are sometimes exceeded. Default probabilities are not identical.

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