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FRM Part II · FRM Exam Part II · Liquidity Transfer Pricing: A Guide to Better Practice

A bank builds its liquidity transfer pricing curve from observable inputs. Which construction is most consistent with better-practice guidance when the bank's own long-term debt market is illiquid at some tenors?

The curve should combine the risk-free yield curve with a liquidity spread estimated from the bank's own issuance plus peer and market proxies, interpolating gaps. This captures the marginal, tenor-specific cost of liquidity, whereas flat, risk-free-only or historical-average approaches distort incentives for business units.

  1. AUse only the bank's last issued bond yield and hold it flat across all tenors
  2. BSet the curve to the risk-free yield curve to avoid subjectivity
  3. CCombine the risk-free curve with a liquidity spread derived from the bank's own issuance, peer data and other market proxies, and interpolate for missing tenorsCorrect
  4. DUse the average historical cost of funds across the balance sheet as a single rate

Explanation

Better practice builds the curve as a risk-free base plus a bank-specific liquidity premium estimated from own issuance and supplementary proxies such as peer spreads, with interpolation where data are sparse. A flat or risk-free curve fails to reflect tenor and the bank's cost, and a historical average is not marginal.

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