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

Which statement best describes a limitation of using the sovereign default spread approach to estimate a country risk premium?

The key limitation is that the default spread reflects risk priced in the sovereign bond market, while equity investors bear more risk than bondholders. Without scaling, the spread may understate the equity country risk premium, which motivates adjusting it by relative equity-to-bond volatility.

  1. AIt cannot be computed for any country that has issued foreign-currency debt
  2. BIt assumes bond market default risk fully reflects the risk faced by equity investors, so the spread may understate equity country risk unless scaledCorrect
  3. CIt requires that the country has no sovereign credit rating
  4. DIt produces a premium that is always larger than that from relative equity market volatility

Explanation

The default spread captures risk priced in the sovereign bond market. Equities are riskier than bonds, so the unscaled spread may understate the equity premium, which is why volatility scaling is used. The approach actually needs foreign-currency debt, and no general ordering with the volatility approach holds.

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