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

Sovereign CDS spreads are often used to gauge default risk. Which statement about the relation between a sovereign CDS spread and the default risk is most accurate?

A sovereign CDS spread approximately equals the annual default probability times loss given default, or one minus the recovery rate. This credit-triangle relation means the spread rises with default likelihood and falls as expected recovery increases.

  1. ASpread approximately equals default probability multiplied by loss given default, i.e. (1 − recovery)Correct
  2. BSpread approximately equals default probability divided by loss given default
  3. CSpread equals the recovery rate multiplied by default probability
  4. DSpread is independent of the expected recovery rate

Explanation

The credit triangle states spread ≈ λ × (1 − R), where λ is the annual default intensity. A higher recovery rate lowers the spread for a given default probability. The other options misstate this relation.

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