FRM Part II · FRM Exam Part II · Liquidity Transfer Pricing: A Guide to Better Practice
A bank builds its LTP curve from its secured and unsecured wholesale funding costs. The 1-year unsecured term funding spread over the risk-free rate is 60 bp, the 5-year spread is 120 bp, and the risk-free 5-year rate is 3.00%. Using the unsecured curve, what 5-year transfer rate should be charged to a bullet 5-year loan?
The 5-year transfer rate is 4.20%, being the 3.00% risk-free rate plus the 1.20% five-year liquidity spread. The matching tenor spread must be used; applying the one-year 60 bp spread would give 3.60% and understate the liquidity cost of the five-year loan.
- A1.20%
- B3.00%
- C4.20%Correct
- D3.60%
Explanation
The transfer rate equals the risk-free rate plus the liquidity spread at the matching tenor: 3.00% + 1.20% = 4.20%. Using 3.60% would wrongly apply the 1-year spread of 0.60%. Using 3.00% omits the liquidity premium altogether.
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