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

A country's 5-year US dollar-denominated government bond yields 7.20%, while a US Treasury of the same maturity yields 4.20%. The bond's yield spread therefore equals 300 basis points. Assuming a recovery rate of 40% and treating the spread as pure compensation for default risk, the approximate annual default probability implied by the spread is:

The implied annual default probability is about 5.00%. The 300 basis point spread compensates for expected loss, which equals default probability times loss given default of 60%, so the probability is 3.00% divided by 0.60.

  1. A3.00%
  2. B5.00%Correct
  3. C1.80%
  4. D7.50%

Explanation

Spread ≈ annual default probability × (1 − recovery). So PD ≈ 3.00% / (1 − 0.40) = 3.00% / 0.60 = 5.00%. Using 3.00% directly ignores recovery; 1.80% multiplies by 0.60 instead of dividing; 7.50% divides by 0.40, using the recovery rate rather than the loss given default.

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