Skip to content

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

A fund has USD 100 million of equity and holds a position with notional USD 600 million through a total return swap, with no cash securities. Why is the balance-sheet leverage ratio a poor measure of its risk?

Balance-sheet leverage can miss derivatives and other synthetic exposures that do not appear as assets. Here the fund controls USD 600 million of exposure on USD 100 million equity, so economic leverage is about 6x even if reported assets-to-equity looks low.

  1. AOff-balance-sheet derivatives exposure is not captured by assets-to-equity, so economic leverage is understatedCorrect
  2. BTotal return swaps always reduce leverage by hedging exposures
  3. CLeverage ratios only apply to deposit-taking institutions
  4. DEquity is always overstated in funds using swaps

Explanation

A synthetic position gives 6x notional exposure to equity but may add little to reported assets under accounting rules. Accounting leverage therefore understates economic leverage. The other options are not true generally.

Did you get it right without looking?

One question tells you little. A timed set on Liquidity and Leverage shows your real accuracy, how long you take and where you lose marks.

Practise Liquidity and LeverageFree diagnostic mock

More Liquidity and Leverage questions