FRM Part II · FRM Exam Part II · Country Risk: Determinants, Measures, and Implications
A risk analyst at a global bank reviews a emerging-market sovereign whose local-currency rating is two notches higher than its foreign-currency rating. Which explanation is most consistent with the typical reasoning behind this gap?
Local-currency ratings are usually higher because a government can create its own currency to service domestic-currency debt, whereas it must earn or borrow foreign currency to repay foreign-currency debt. This asymmetry makes foreign-currency default more likely, producing the notch gap.
- AThe government can print its own currency to service local-currency debt, but cannot print foreign currency to repay foreign-currency debtCorrect
- BLocal-currency debt is always guaranteed by multilateral agencies
- CForeign-currency debt is always senior to local-currency debt in bankruptcy courts
- DLocal-currency bonds carry no inflation risk for investors
Explanation
A sovereign controls its own central bank and can create local currency to meet local obligations, so default risk on that debt is generally lower. It cannot create foreign currency, so foreign-currency debt faces additional transfer and reserve constraints. The other options state false or irrelevant claims; local debt can still carry inflation risk, but that is not the reason for the rating gap.
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