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

Over several weeks, a euro-area sovereign's CDS spread rises sharply while the spreads on the country's banks' CDS also widen by a similar amount. Which interpretation best reflects the sovereign-bank feedback relationship often discussed in country risk analysis?

Sovereign and bank credit risk reinforce each other. Weak banks raise sovereign risk through potential bailout costs, while a weaker sovereign hurts banks through losses on government bond holdings and reduced state support. This two-way loop explains why their CDS spreads move together.

  1. ASovereign and bank credit risk are independent, so the co-movement is a coincidence
  2. BBank weakness can raise sovereign risk through bailout costs, and sovereign weakness can raise bank risk through losses on holdings of government bondsCorrect
  3. COnly bank risk can affect sovereign spreads, because sovereigns can always print currency
  4. DSovereign CDS spreads should always remain wider than bank CDS spreads, so the co-movement signals mispricing

Explanation

The sovereign-bank loop runs both ways: bailout costs and contingent liabilities transmit bank stress to the sovereign, while banks' holdings of sovereign debt and reliance on state support transmit sovereign stress to banks. A euro-area member cannot print its own currency, so the third option fails. Independence and a fixed ordering are not supported.

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