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

A risk analyst compares a country's local-currency sovereign rating with its foreign-currency sovereign rating. Across most rated emerging markets, which pattern does Damodaran's country risk reading describe, and why?

Local-currency sovereign ratings are usually equal to or higher than foreign-currency ratings, because a government can print its own currency to repay domestic debt, whereas repaying foreign-currency debt requires obtaining hard currency it cannot create.

  1. ALocal-currency ratings are typically equal to or higher than foreign-currency ratings, because a government can print its own currency to meet local obligationsCorrect
  2. BLocal-currency ratings are typically lower than foreign-currency ratings, because inflation erodes local debt values
  3. CLocal-currency and foreign-currency ratings are always identical because both reflect the same fiscal position
  4. DForeign-currency ratings are typically higher because foreign creditors have stronger legal claims on the government

Explanation

A government can create its own currency to service local-currency debt, so default on it is less likely than on foreign-currency debt, which requires acquiring hard currency. Local-currency ratings are therefore usually equal to or higher. The option claiming lower local ratings reverses this logic.

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