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

A bank's 10-year mortgage portfolio has an expected life of 6 years because of prepayments. Term funding costs are 2.50% at 6 years and 3.00% at 10 years. Which transfer rate component should the treasury apply for liquidity on these mortgages under better practice?

Apply 2.50%, the term funding cost at the six-year expected life. Better-practice LTP prices assets using behavioral maturity that reflects prepayments, not contractual maturity. Using the 10-year rate would overcharge the mortgage unit, while an average or overnight rate has no basis in the asset's liquidity profile.

  1. A3.00%, the contractual maturity rate
  2. B2.50%, the rate for the behavioral maturityCorrect
  3. C2.75%, the average of the two tenors
  4. DThe overnight rate, since prepayments make the assets short-term

Explanation

Assets are priced on their expected, behaviorally adjusted liquidity profile, so the 6-year funding rate of 2.50% applies. The 3.00% rate uses contractual maturity and would overcharge. The average has no basis, and overnight ignores the 6-year expected life.

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