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

An analyst estimates Country Z's default spread two ways. Method 1 uses the rating (Ba1) average spread of 2.4%. Method 2 uses the country's 10-year US dollar bond yield of 7.6% against a US Treasury yield of 4.0% from the same date. Sovereign CDS spread is 3.1%. The analyst concludes the market views Country Z as riskier than the Ba1 rating implies. Which statement best supports and qualifies this conclusion?

Yes. The bond spread of 3.6% (7.6% minus 4.0%) and the 3.1% CDS spread both exceed the 2.4% rating-based spread, implying higher perceived risk, but the bond spread also embeds liquidity and risk premiums, so it overstates pure default risk.

  1. AYes; the bond spread of 3.6% exceeds 2.4%, though bond spreads include liquidity and other premiums beyond pure default riskCorrect
  2. BNo; the bond spread of 3.6% is below the CDS spread so risk is lower than rated
  3. CYes; but only the CDS spread should be used because it contains no risk premium
  4. DNo; the rating spread of 2.4% always dominates market-based measures

Explanation

Bond spread = 7.6% - 4.0% = 3.6%, above the 2.4% rating-based spread, and the CDS of 3.1% also exceeds it, so markets imply higher risk. However, bond spreads contain liquidity and risk premium components, so they overstate pure expected loss. The claim that 3.6% is below the CDS is arithmetically wrong.

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