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

A risk analyst at a global bank compares sovereign ratings from a rating agency with the yield spreads that the same sovereigns pay in the market. Which statement best reflects the typical relationship described in the Damodaran country risk reading?

Sovereign ratings are sticky and often lag the market, because agencies change them only after committee review. Bond yield spreads and CDS prices react quickly to new information and vary within a rating category, so market-implied default risk usually moves before ratings do.

  1. ASovereign ratings are updated continuously and always lead market spreads
  2. BSovereign ratings tend to be sticky and often lag market-implied default risk, which is reflected more quickly in spreadsCorrect
  3. CSovereign ratings are derived directly from credit default swap spreads
  4. DMarket spreads on sovereign bonds are fixed by the rating category and cannot differ within it

Explanation

Ratings are produced by committees and changed infrequently, so they are slow to reflect new information. Market spreads and CDS levels respond immediately and vary widely within a rating class. The option claiming ratings lead spreads reverses the actual relationship.

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