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

A risk analyst observes that a country's 5-year sovereign CDS spread is 180 bp, while the spread of its 5-year USD-denominated government bond over the comparable Treasury is 230 bp. Which of the following is the most reasonable interpretation?

The 50 bp difference can reasonably reflect non-default components such as bond liquidity premia, plus CDS-specific factors like counterparty risk and contract terms. Exact equality is not guaranteed in practice, so the gap does not by itself prove mispricing or a data error.

  1. AThe CDS market is pricing a lower default risk than the bond market, and a positive CDS-bond gap of 50 bp indicates the CDS is overvalued by exactly that amount
  2. BThe two measures must be equal in a no-arbitrage market, so the data is certainly erroneous
  3. CThe bond spread may include liquidity and other non-default components, and CDS may reflect counterparty and contract-specific factors, so the 50 bp difference does not necessarily imply pure default-risk disagreementCorrect
  4. DThe CDS spread is lower because CDS spreads exclude all default risk and capture only currency risk

Explanation

Bond spreads include liquidity premia and other factors, while CDS prices reflect supply and demand, counterparty risk and contract terms (such as restructuring definitions). Basis differences are common in practice, so they do not prove mispricing or error. Option 1 wrongly asserts overvaluation; option 2 ignores frictions; option 4 is false because CDS directly prices default.

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