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FRM Part II · FRM Exam Part II · Monitoring Liquidity

A bank funds a 10-year loan book of USD 800 million with USD 500 million of overnight wholesale funding and USD 300 million of equity. Which statement best describes the principal liquidity risk and its relation to interest rate risk?

The main exposure is rollover risk from funding long-dated illiquid loans with USD 500 million of overnight borrowing. If lenders withdraw, the bank must sell assets or borrow on distressed terms, and interest rate hedging does not remove this funding-access problem.

  1. ARollover risk: the funding must be renewed daily, so a loss of market access forces asset sales or emergency borrowing, even if the interest rate position is hedgedCorrect
  2. BCredit risk only, since equity covers the whole loan book
  3. CBasis risk only, because assets and liabilities are in the same currency
  4. DNo material risk, as overnight funding is the cheapest source

Explanation

USD 500 million of liabilities must be refinanced every day against illiquid 10-year assets, a maturity mismatch. A hedge can fix interest costs but does not guarantee access to funding. Equity of USD 300 million covers only part of the assets, not the funded gap.

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