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

A risk manager notes that the sovereign CDS spread for Country Y has risen sharply over the past month, although no rating agency has changed its rating on the sovereign. Which interpretation is most consistent with the properties of market-based measures compared with ratings?

The rise in the CDS spread likely signals worsening perceived credit risk ahead of any rating action, because ratings adjust slowly and aim for through-the-cycle stability, whereas CDS prices respond immediately to new information. A higher spread means higher, not lower, perceived default risk.

  1. ARatings are typically slower to adjust, so the CDS spread may be signalling a deterioration in perceived risk before a rating actionCorrect
  2. BThe CDS spread must be wrong, because ratings are always more accurate indicators of default risk
  3. CRising CDS spreads show that the sovereign's default probability has fallen
  4. DThe CDS market is irrelevant because sovereign ratings are updated daily

Explanation

Ratings are updated infrequently and aim for stability through the cycle, while CDS spreads react immediately to new information. A rising spread signals higher perceived risk, not lower. Ratings are not updated daily, so the other options are incorrect.

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