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

A government with substantial foreign-currency-denominated debt faces a sharp fall in export revenues and a depletion of its foreign reserves. Which statement best describes the resulting source of country risk and its likely consequence?

Sovereign default risk rises, because the government cannot print foreign currency and falling export revenues and reserves leave it short of hard currency to service foreign-denominated debt. The ability to print local currency does not solve this problem, so default on foreign-currency debt becomes more likely.

  1. ASovereign default risk rises because the government lacks the hard currency to service debt, and it may default even though it could print local currencyCorrect
  2. BSovereign default risk is unaffected because a government can always print the currency in which its debt is denominated
  3. COnly local-currency sovereign ratings fall, since foreign-currency debt ratings are insulated by reserves
  4. DExpropriation risk falls because the government has stronger incentives to protect foreign investors

Explanation

A government cannot print foreign currency. When export earnings and reserves fall, it may be unable to meet foreign-currency obligations, so default risk on that debt rises. Option B applies only to local-currency debt, and reserves are depleted here, so C is wrong.

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