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FRM Part II · FRM Exam Part II · Liquidity Risk Management

A dealer finances $100 million of securities through overnight repo with a 2% haircut and funds the haircut with its own capital. In a stress event the repo lender raises the haircut to 10%, and the dealer cannot raise new capital. What is the additional liquidity the dealer must find, and what is the best interpretation?

The dealer must find an extra $8 million. Borrowing falls from $98 million to $90 million on the same collateral when the haircut rises from 2% to 10%. The haircut increase works like a margin call and drains liquidity.

  1. A$8 million; haircut increases act as a margin call that requires additional fundingCorrect
  2. B$10 million; the full haircut must be funded on top of the original amount
  3. C$2 million; only the original haircut is relevant
  4. D$8 million; this reduces the dealer's funding need because less cash is borrowed

Explanation

Cash borrowed falls from 98 to 90 million at the same collateral value, so the dealer must replace 8 million of financing. This is a liquidity drain like a margin call. The 10 million option ignores the 2 million already funded; 2 million ignores the increase; the last option misreads the direction of the cash flow.

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