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

A risk analyst at an investment bank compares two measures of sovereign default risk for the same government: the agency's foreign-currency rating and the local-currency rating. The government borrows heavily in its own currency and controls its central bank. Based on Damodaran's discussion of sovereign ratings, which observation is most consistent with agency practice?

Local-currency ratings are usually equal to or higher than foreign-currency ratings, because a government can create its own currency to repay local debt but cannot print hard currency to repay foreign-currency obligations, so default risk on foreign-currency debt is greater.

  1. AThe local-currency rating is typically equal to or higher than the foreign-currency ratingCorrect
  2. BThe local-currency rating is typically lower than the foreign-currency rating
  3. CBoth ratings must always be identical because default is a single event
  4. DLocal-currency ratings are set by the central bank rather than the agency

Explanation

A government can print its own currency to service local-currency debt, so agencies usually assign a local-currency rating equal to or above the foreign-currency rating. Foreign-currency debt requires access to hard currency that the government cannot create. Saying the local rating is lower reverses this logic.

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