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

A bank prices liquidity for a portfolio of high-quality liquid bonds held by a trading desk and a portfolio of illiquid private loans held by a lending unit, both with 7-year contractual maturity. The treasury proposes charging both the same 7-year term liquidity rate. Which critique best reflects better practice?

Charging the same rate ignores that the high-quality bonds can be sold or repoed quickly, so their liquidity cost should be lower than for the illiquid loans. Better practice prices assets by their liquidity characteristics and monetization ability, not just contractual maturity.

  1. AThe approach is correct because contractual maturity is the only objective measure
  2. BThe approach overcharges the lending unit relative to the desk, since loans are always more liquid
  3. CThe approach ignores that the bonds can be monetized quickly via repo or sale, so their liquidity cost should be lower than that of the illiquid loansCorrect
  4. DThe approach should instead charge both at the overnight rate to simplify allocation

Explanation

Better practice prices assets by liquidity characteristics, including the ability to be sold or financed, not only contractual maturity. Liquid bonds require less term funding and may even be a source of liquidity, whereas illiquid loans need full-term funding. The loans are the less liquid assets, so option about overcharging them is wrong.

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