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

A bank funds a 5-year fixed-rate loan with no prepayment option using its funds transfer pricing curve. The 5-year matched-maturity funding rate is 4.0%, while the overnight rate is 2.5%. The business unit is charged 2.5% to keep its reported margin high. Which is the most likely consequence?

Charging the overnight rate for a five-year loan understates its funding cost by 1.5 percentage points, so the business unit's profit is overstated. It encourages excess long-term lending while Treasury retains the unpriced refinancing and liquidity risk, which is contrary to matched-maturity transfer pricing practice.

  1. AThe unit's profitability is overstated and the bank takes on unpriced liquidity and refinancing risk held centrallyCorrect
  2. BThe unit's profitability is understated and it will under-originate long loans
  3. CThe bank eliminates its interest rate risk because the charge is lower
  4. DThe loan will be repriced immediately to the overnight rate for customers

Explanation

Matched-maturity funding should be charged to reflect the term liquidity premium. Charging 2.5% instead of 4.0% understates the funding cost by 1.5% a year, overstating unit profit and encouraging excessive long-term lending. The refinancing risk remains with Treasury unpriced. The understated option has the sign reversed.

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