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

During a regional crisis, the sovereign CDS spread of Country A widens from 150 bps to 400 bps while its credit rating is unchanged. Which interpretation is most appropriate for a risk manager?

The wider CDS spread suggests the market is pricing more default risk, or demanding a higher risk premium, than the unchanged rating reflects. Market spreads react faster than ratings, so the rating may lag. The widening does not prove an imminent default.

  1. AThe market is pricing higher default risk or risk premium than the rating reflects, so the rating may lag market informationCorrect
  2. BThe widening proves the rating is correct and the sovereign will default within a year
  3. CThe CDS market is irrelevant because ratings are the only valid measure of sovereign risk
  4. DThe widening reflects only a change in recovery assumptions and has no information about default risk

Explanation

CDS spreads respond quickly to new information and to changes in risk aversion, whereas ratings adjust slowly. A large widening without a rating change suggests the market sees more risk or demands a higher premium than the rating implies. It does not prove default, and spreads contain default risk and risk premium rather than only recovery.

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