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

A dealer bank funds a portfolio of long-dated corporate bonds almost entirely with overnight secured repo. A risk manager warns that the funding structure creates significant rollover risk. Which description best captures the core source of this risk?

The core source is a maturity mismatch: overnight funding must be renewed repeatedly while the bonds are long-dated. If lenders refuse to roll or raise haircuts, the bank cannot refinance its assets on acceptable terms, creating funding liquidity stress even without any default on the collateral.

  1. AThe bonds may default before the repo matures, causing a credit loss on the collateral
  2. BShort-term funding must be renewed repeatedly, so the bank may be unable to refinance its long-dated assets at acceptable terms or at allCorrect
  3. COvernight repo rates are always higher than long-term bond yields, creating negative carry
  4. DRepo transactions are not collateralized, so lenders face unsecured exposure

Explanation

Rollover risk arises from a maturity mismatch: long-dated assets financed with very short-term liabilities must be refinanced continually. If lenders withdraw or raise haircuts, the bank may be unable to roll the funding. Credit loss on the bonds and negative carry are separate issues, and repo is collateralized.

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