Learning outcomes: Describe the consequences of sovereign default. Describe factors that influence the level of sovereign default risk; explain and assess how rating agencies measure sovereign default risks. Describe the advantages and disadvantages of using the sovereign default spread as a predictor of defaults.
Questions:
602.1. Each of the following dynamic factors, ceteris paribus, should tend to INCREASE the level of sovereign debt risk EXCEPT which does not increase the probability of sovereign default?
a. Higher percent of government debt divided by gross domestic product (GDP)
b. Larger tax base in an diversified economy that depends highly on value-added taxes (VAT)
c. Higher ratio of tourism as a proportion of an overall economy that is not well diversified
d. Higher old-age dependency ratio; i.e., number of people retirement aged and older divided by number of working-age adults
602.2. In designing its sovereign bond investment evaluation methodology, the Investment Committee at your firm is deciding whether to incorporate sovereign credit ratings by major firms (namely S&P, Moody's, and/or Fitch). Your colleague Mary asserts that your firm should NOT depend on sovereign credit ratings by major firms. She makes the four arguments below. According to Damodaran, which of her arguments below is the MOST persuasive?
a. Credit rating agencies have a conflict of interests with respect to sovereign ratings
b. For any given sovereign bond, there is very little consistency among the agencies such that any almost rating can be justified
c. Agencies take too long to change sovereign ratings, including the special case of an overly-optimistic rating that fails to anticipate deep sovereign risk only to suddenly downgrade the sovereign multiple times in s short period of time
d. Historical analysis comparing sovereign ratings to actual sovereign defaults generally produce no statically meaningful correlation; i.e., default rates of investment grade sovereign bonds are not statistically less than default rates of speculative sovereign bonds
602.3. Damodaran explains the sovereign default spread as follows: "When a government issues bonds, denominated in a foreign currency, the interest rate on the bond can be compared to a rate on a riskless investment in that currency to get a market measure of the default spread for that country. To illustrate, the Brazilian government had a 10-year dollar denominated bond outstanding in July 2015, with a market interest rate of 4.5%. At the same time, the 10-year US treasury bond rate was 2.47%. If we assume that the US treasury is default free, the difference between the two rates can be attributed (2.03%) can be viewed as the market’s assessment of the default spread for Brazil."
According to Damodaran, in regard to the relationship between sovereign default spreads, sovereign (agency) ratings and ultimate default rates, each of the following is true EXCEPT which is not?
a. A change in sovereign ratings is still an informational event that creates a price impact at the time that it occurs.
b. In general higher sovereign default spreads correlate with lower-quality sovereign ratings and higher rates of ultimate default
c. The sovereign bond market leads ratings agencies, with default spreads usually climbing ahead of a rating downgrade and dropping before an upgrade
d. Sovereign ratings are not useful because neither do sovereign ratings inform the market prices of sovereign bonds nor, in the other direction, does market data inform changes in sovereign ratings by rating agencies
Answers here:
Questions:
602.1. Each of the following dynamic factors, ceteris paribus, should tend to INCREASE the level of sovereign debt risk EXCEPT which does not increase the probability of sovereign default?
a. Higher percent of government debt divided by gross domestic product (GDP)
b. Larger tax base in an diversified economy that depends highly on value-added taxes (VAT)
c. Higher ratio of tourism as a proportion of an overall economy that is not well diversified
d. Higher old-age dependency ratio; i.e., number of people retirement aged and older divided by number of working-age adults
602.2. In designing its sovereign bond investment evaluation methodology, the Investment Committee at your firm is deciding whether to incorporate sovereign credit ratings by major firms (namely S&P, Moody's, and/or Fitch). Your colleague Mary asserts that your firm should NOT depend on sovereign credit ratings by major firms. She makes the four arguments below. According to Damodaran, which of her arguments below is the MOST persuasive?
a. Credit rating agencies have a conflict of interests with respect to sovereign ratings
b. For any given sovereign bond, there is very little consistency among the agencies such that any almost rating can be justified
c. Agencies take too long to change sovereign ratings, including the special case of an overly-optimistic rating that fails to anticipate deep sovereign risk only to suddenly downgrade the sovereign multiple times in s short period of time
d. Historical analysis comparing sovereign ratings to actual sovereign defaults generally produce no statically meaningful correlation; i.e., default rates of investment grade sovereign bonds are not statistically less than default rates of speculative sovereign bonds
602.3. Damodaran explains the sovereign default spread as follows: "When a government issues bonds, denominated in a foreign currency, the interest rate on the bond can be compared to a rate on a riskless investment in that currency to get a market measure of the default spread for that country. To illustrate, the Brazilian government had a 10-year dollar denominated bond outstanding in July 2015, with a market interest rate of 4.5%. At the same time, the 10-year US treasury bond rate was 2.47%. If we assume that the US treasury is default free, the difference between the two rates can be attributed (2.03%) can be viewed as the market’s assessment of the default spread for Brazil."
According to Damodaran, in regard to the relationship between sovereign default spreads, sovereign (agency) ratings and ultimate default rates, each of the following is true EXCEPT which is not?
a. A change in sovereign ratings is still an informational event that creates a price impact at the time that it occurs.
b. In general higher sovereign default spreads correlate with lower-quality sovereign ratings and higher rates of ultimate default
c. The sovereign bond market leads ratings agencies, with default spreads usually climbing ahead of a rating downgrade and dropping before an upgrade
d. Sovereign ratings are not useful because neither do sovereign ratings inform the market prices of sovereign bonds nor, in the other direction, does market data inform changes in sovereign ratings by rating agencies
Answers here:
