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FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management

A bank classifies a USD 200 million bond portfolio as held-to-maturity (amortized cost) rather than available-for-sale (fair value through equity). Market yields rise and the portfolio's fair value falls to USD 188 million. Which statement is most accurate regarding the bank's reported position and risk?

Reported capital is not immediately affected because amortized cost ignores the fair value decline, but the USD 12 million economic loss is real. If the bank must sell or pledge the bonds, the loss is realized or haircut at market value, hurting liquidity.

  1. AReported capital shows no immediate effect from the USD 12 million decline, but the economic loss is real and limits liquidity if the bonds must be soldCorrect
  2. BThe USD 12 million loss reduces reported capital immediately through equity
  3. CThe decline is irrelevant because held-to-maturity bonds can always be pledged at par
  4. DThe loss disappears because yield rises increase amortized cost

Explanation

Amortized cost accounting does not recognize fair value changes in capital, but the economic loss exists. If forced sales occur, the loss is realized and the bank's liquidity is impaired; collateral is valued at market, not par.

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