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

A bank holds a portfolio of high-quality liquid government bonds that can be sold or repoed readily in stress. Under good LTP practice, how should the liquidity value of this buffer be treated for the business unit holding it?

The negative carry of the liquidity buffer should be allocated to the business activities that create the contingent liquidity need. This makes the cost of holding liquid assets visible in pricing, instead of leaving it unassigned in treasury or booking it as profit.

  1. ACharge the unit the full term funding rate with no offset, since the bonds are assets
  2. BRecognize the liquidity buffer's cost as the carry between funding cost and bond yield, and allocate it to the units whose activities create the contingent liquidity need rather than leaving it unallocatedCorrect
  3. CIgnore the buffer in LTP because it is held by treasury
  4. DCredit the holding unit with the full stress liquidity premium as profit

Explanation

The buffer is held to cover contingent liquidity risks, and its negative carry should be allocated to the activities generating that risk. Ignoring it leaves costs unassigned, while crediting a premium as profit misrepresents it.

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