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

A hedge fund finances a portfolio with short-term repo borrowing. In a stressed market, its prime broker raises haircuts on the collateral and shortens the funding maturity. Which description best captures the funding liquidity risk the fund now faces?

Funding liquidity risk is the danger that a firm cannot meet margin calls, collateral demands or rollover needs when due, forcing asset sales. Higher haircuts and shorter repo maturities raise cash needs, so this applies. Inability to sell at mid price is market liquidity risk.

  1. AThe risk that the fund cannot sell its assets at the quoted mid price without moving the market
  2. BThe risk that the fund cannot meet margin or collateral calls and rollover needs without being forced to liquidate positionsCorrect
  3. CThe risk that the fund's assets lose value because of a rise in default probabilities
  4. DThe risk that the fund's benchmark index differs from the fund's actual holdings

Explanation

Funding liquidity risk is the risk of being unable to meet cash, margin or collateral obligations as they fall due. Higher haircuts and shorter maturities increase the cash needed and the rollover frequency. Option 0 describes market liquidity risk, not funding liquidity risk.

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