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

An analyst observes that a sovereign's 5-year CDS spread is 240 basis points, while the spread on its 5-year foreign-currency bond over a risk-free benchmark, adjusted for comparable floating-rate terms, is 190 basis points. Absent frictions, the two should be close. Which explanation is most consistent with the CDS spread exceeding the bond spread?

Heavy demand for protection from investors hedging other exposures to the country, such as local banks or corporates, can push the CDS spread above the bond spread. This hedging demand is a non-default factor that widens the basis between the two measures.

  1. AThe CDS contract is priced on the bond's coupon rather than on default risk
  2. BInvestors use CDS to hedge exposures to the country, such as local banking or corporate positions, adding demand for protectionCorrect
  3. CThe bond is more liquid than the CDS, which forces its yield spread above the CDS spread
  4. DSovereign CDS contracts carry no counterparty risk, so they trade at a premium

Explanation

Hedging demand for protection, including proxy hedges of other country exposures, can push CDS spreads above bond spreads, creating a positive basis. The liquidity story in the third option would raise the bond spread, the opposite of the observed gap. CDS contracts do carry counterparty risk, and they are not priced off the coupon.

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