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FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks

A dealer bank is the clearing party for OTC derivatives and its credit rating is downgraded by two notches. Its contracts contain rating-based triggers. Which consequence most directly increases its fragility?

Rating-based triggers let derivative counterparties demand more collateral or terminate trades after a downgrade. That creates sudden cash needs just as funding becomes scarce, worsening the dealer's liquidity position and speeding a downward spiral toward failure.

  1. ACounterparties may demand additional collateral or terminate contracts, raising immediate liquidity needsCorrect
  2. BThe dealer's derivative liabilities are automatically written down
  3. CIts counterparties must return previously posted collateral
  4. DThe dealer's capital requirement for market risk is cut

Explanation

Rating triggers let counterparties call extra margin or close out trades after a downgrade. This creates sudden cash demands precisely when funding is scarce, feeding a downward spiral. Returning collateral or write-downs would help the dealer rather than hurt it.

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