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

A risk analyst at an international bank reviews the sovereign credit ratings of several emerging economies. According to Damodaran's discussion of country risk, which of the following is the most accurate statement about sovereign default?

Sovereign defaults on foreign currency debt are more frequent than on local currency debt because a government can print its own currency to repay local obligations but cannot print hard currency. Local currency default is still possible, including through inflation, so it is not impossible.

  1. ASovereign default on local currency debt is as likely as default on foreign currency debt because both depend on the same resources
  2. BSovereign defaults on foreign currency debt are typically more frequent than on local currency debt, because a government can print its own currency to service local debtCorrect
  3. CA government that borrows only in its own currency can never default in any form
  4. DSovereign ratings are assigned only to foreign currency debt and never to local currency debt

Explanation

A government can print its own currency to meet local currency obligations, so default on that debt is less likely, though it may occur through inflation or in some cases through actual default. Foreign currency debt requires hard currency the government cannot print, so default on it is more frequent. Option A ignores this difference; C is too absolute because governments have defaulted on local debt or inflated it away.

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