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

A portfolio manager holds equities in an emerging market whose sovereign rating has just been downgraded. Which is the most likely implication for the manager's holdings of companies in that country?

A sovereign downgrade most likely raises required returns and lowers equity valuations for domestic companies. Higher country risk feeds into funding costs and discount rates, and many firms are constrained by the sovereign's creditworthiness, so the effect reaches equities as well as bonds.

  1. AHigher required returns and lower valuations, even for companies with limited domestic exposureCorrect
  2. BLower required returns for all domestic companies because the government will support them
  3. CNo effect on valuations because ratings only affect bond prices
  4. DHigher valuations for companies, because currency weakness always raises equity values

Explanation

A sovereign downgrade signals greater country risk, which raises required returns and lowers valuations. Firms often face rating ceilings and higher funding costs tied to the sovereign. Effects extend beyond bonds to equities.

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