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FRM Part II · FRM Exam Part II · Managing Nondeposit Liabilities

A bank's treasurer needs overnight funding and borrows reserve balances from another depository institution on an unsecured basis in the US federal funds market. Which statement best describes this transaction?

A federal funds transaction is an unsecured, usually overnight, loan of reserve balances between depository institutions at a negotiated rate. Unlike a repo, no collateral is pledged and no securities are sold and repurchased, so the lender bears unsecured counterparty credit risk.

  1. AIt is an unsecured overnight loan of reserve balances, with the interest rate set by negotiation between the partiesCorrect
  2. BIt is a secured loan in which Treasury securities are pledged as collateral and subject to a haircut
  3. CIt is a sale of securities with an agreement to repurchase them at a higher price
  4. DIt is a term deposit placed with the Federal Reserve at the discount rate

Explanation

Federal funds are unsecured, typically overnight, loans of reserve balances between institutions, at a negotiated rate. Collateral and haircuts characterize repos, not fed funds. The repurchase-at-a-higher-price structure also describes repos.

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