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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 two ways of gauging the default risk of a government that issues bonds in foreign currency. One approach uses the rating agency's sovereign rating, and the other uses the sovereign credit default swap (CDS) spread. Which statement best describes an advantage of the CDS spread over the rating?

The sovereign CDS spread is a market price that updates continuously with new information, while agency ratings are revised infrequently and tend to lag. The spread still contains risk premia and liquidity effects, and it exists only for a limited set of sovereigns.

  1. AIt is updated continuously as market views change, whereas ratings change infrequentlyCorrect
  2. BIt is free of liquidity and risk-premium effects, so it equals the pure default probability
  3. CIt is available for every sovereign, including those with no traded debt
  4. DIt measures only the loss given default, not the probability of default

Explanation

CDS spreads are market prices that move daily with new information, while ratings are revised only occasionally and lag the market. CDS spreads are not free of risk premia or liquidity effects, so the second option is wrong. CDS markets cover only a limited set of sovereigns, and the spread reflects both default probability and loss severity.

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