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

A risk manager notes that a country's sovereign rating was upgraded, causing its sovereign bond default spread to narrow from 4.0% to 2.5%, while the ratio of equity to bond volatility stays at 1.5. Holding the mature-market premium constant, what is the change in the country risk premium under the relative volatility approach?

The country risk premium falls by 2.25 percentage points. It moves from 6.0% (4.0% spread times 1.5) to 3.75% (2.5% times 1.5). The unscaled spread change of 1.5% understates the effect because equity volatility scaling applies.

  1. ADecrease of 1.5%
  2. BDecrease of 2.25%Correct
  3. CDecrease of 3.75%
  4. DIncrease of 2.25%

Explanation

Old CRP = 4.0% x 1.5 = 6.0%. New CRP = 2.5% x 1.5 = 3.75%. Change = -2.25%. The 1.5% option ignores the volatility scaling, and 3.75% is the new CRP level rather than the change.

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