CFA Level I · CFA Level I Exam · Fixed-Income Markets for Government Issuers
A country has a fixed exchange rate against a major currency. Its foreign reserves are declining steadily and its central bank is defending the peg. For holders of the country's local-currency sovereign bonds, the most likely risk is:
The most likely risk is devaluation. Declining reserves weaken the central bank's ability to defend the peg, so the currency may be forced lower, cutting returns for investors measured in the foreign currency. A peg does not remove currency risk when reserves are dwindling.
- Adevaluation of the currency, which would reduce returns measured in the foreign currencyCorrect
- Ban immediate upgrade because pegs eliminate currency risk
- Clower inflation caused by the falling reserves
Explanation
Falling reserves signal that the peg may be abandoned, so devaluation is likely, harming foreign investors' returns. Pegs do not remove currency risk when reserves are inadequate. Falling reserves do not imply lower inflation; devaluation would tend to increase it.
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