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

A sovereign credit default swap (CDS) on Country X trades at a spread of 240 basis points per year. Under the approach in which the CDS market is used to estimate a country default spread, which statement best describes how this spread is interpreted?

A sovereign CDS spread is the annual price of protection against a sovereign credit event, so it gives a market-based estimate of the country default spread. It is not an equity risk premium, a rating differential, or an exchange rate forecast.

  1. AIt is the market price of insurance against a sovereign credit event, and can be used as a market-based estimate of the country default spreadCorrect
  2. BIt is the country's equity risk premium over the risk-free rate
  3. CIt is the difference between the local currency and foreign currency sovereign ratings
  4. DIt is the expected annual change in the exchange rate of the country

Explanation

A sovereign CDS spread is the annual premium paid to protect against a sovereign credit event, so it reflects market-implied default risk. Analysts use it as a market-based default spread. It is not an equity premium, a ratings notch gap, or an FX forecast.

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