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

A bank's treasury uses a 1-year funding rate of 3.20% and a 5-year funding rate of 4.60% (both including liquidity spreads). A business unit books a 5-year amortising loan whose behavioural duration of cash flows is estimated at 3 years. The 3-year rate on the curve is 3.90%. Under a duration-matched (weighted-average-life) approach, what transfer rate applies?

The applicable transfer rate is 3.90%. An amortising loan is priced at the curve point matching the average life of its cash flows, here 3 years, rather than its 5-year contractual maturity. Using 4.60% would overcharge the business, while 3.20% would understate the funding tenor.

  1. A3.20%
  2. B3.90%Correct
  3. C4.25%
  4. D4.60%

Explanation

For an amortising asset, the transfer price is taken at the tenor matching the weighted average life of the cash flows, not the contractual maturity. With a 3-year average life, the 3-year curve point of 3.90% is used. The 4.60% rate would wrongly use contractual maturity, and 4.25% is an unjustified average of the end points.

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