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

A risk analyst at a bank reviews a emerging-market sovereign whose government debt is mostly denominated in US dollars, while its tax revenues are almost entirely in local currency. Which feature most directly explains why this sovereign is exposed to a higher default risk than a comparable sovereign borrowing in its own currency?

Foreign-currency debt is riskier because the government cannot print the foreign currency needed to repay it. If the local currency depreciates, debt service costs rise relative to local-currency tax revenue, raising the probability of default compared with debt issued in its own currency.

  1. AIt cannot print foreign currency to meet its obligations, so a currency depreciation raises the local-currency burden of debt serviceCorrect
  2. BIt can always meet foreign-currency debt by raising local interest rates
  3. CIts local-currency revenues automatically rise when the currency weakens
  4. DForeign-currency debt carries no rollover risk

Explanation

A government can create its own currency to pay local-currency debt, but not foreign currency. When the local currency depreciates, the cost of servicing dollar debt rises relative to local-currency revenue, increasing default risk. The other options misstate how foreign-currency debt behaves.

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