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FRM Part II · FRM Exam Part II · Liquidity and Leverage

A broker-dealer funds a portfolio of long-dated, hard-to-value securities with overnight repo. A risk manager notes that a small rise in haircuts or a loss of lender confidence could force rapid asset sales. Which description best identifies the core funding liquidity risk in this structure?

The core funding liquidity risk is rollover risk from the maturity mismatch: long-dated, illiquid assets financed with overnight repo must be refinanced daily, so lender withdrawal or higher haircuts can force fire sales.

  1. ABasis risk between the repo rate and the securities' coupon
  2. BRollover risk arising from a maturity mismatch between assets and liabilitiesCorrect
  3. CModel risk from mispricing the securities
  4. DSettlement risk from delivering collateral late

Explanation

Financing long-dated illiquid assets with overnight borrowing creates a maturity mismatch, so the firm must roll its funding every day. If lenders refuse to roll or raise haircuts, it must sell assets or find other funding. Basis risk is a rate issue and does not threaten the ability to fund.

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