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

A bank holds bonds in a portfolio that is accounted for at amortized cost because the business model is to hold to collect contractual cash flows. Rates rise sharply and the bonds show large unrealized market losses. Which liquidity risk consideration is most relevant?

Raising cash by selling amortized-cost bonds would realize the hidden market losses, and sales could undermine the hold-to-collect classification. The accounting treatment does not change the market value actually obtainable, so the portfolio's true liquidity value is below book value.

  1. AThe unrealized losses must be recognized immediately in regulatory capital and cannot affect liquidity
  2. BSelling the bonds to raise cash would crystallize the losses and may call into question the hold-to-collect classificationCorrect
  3. CThe bonds can be sold at book value because amortized cost sets their market price
  4. DThe losses reduce the bank's liquidity only if the bonds are reclassified as trading

Explanation

Amortized cost hides unrealized losses in earnings, but liquidity from the bonds is available only at market value. Selling realizes the loss and frequent or significant sales can taint the business model. Book value does not determine the sale price.

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