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

A sovereign CDS spread for Country Z is 300 bps, while its dollar bond spread over Treasuries is 240 bps. Which is the most plausible explanation for the CDS spread exceeding the bond spread?

The CDS spread can exceed the bond spread because CDS prices reflect factors such as counterparty risk, liquidity premia, demand for protection, and the delivery option, which a simple bond spread does not capture. The two measures need not be equal.

  1. AThe CDS spread is always lower than the bond spread by construction
  2. BCDS premiums include a rating-agency adjustment that bonds do not
  3. CCDS spreads embed only currency risk, not default risk
  4. DCDS pricing may include counterparty risk, liquidity premia, and the cheapest-to-deliver option, which the bond spread does not captureCorrect

Explanation

CDS and bond spreads can diverge because of liquidity, counterparty risk, supply and demand for protection, and delivery options. CDS does not reflect only currency risk, and no rating-agency adjustment is built into premiums. Nothing makes CDS lower by construction.

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