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FRM Part II · FRM Exam Part II · Repurchase Agreements and Financing

A money market fund lends cash through tri-party repos. A risk manager reviews its exposure to a dealer that has just been downgraded. Which measure best limits the fund's loss if the dealer defaults while the collateral value falls?

The fund should take high-quality, diversified collateral with a haircut reflecting liquidation time and price volatility. This keeps collateral value above the cash lent even if prices fall after default. Own-issuer bonds create wrong-way risk, and lower haircuts or longer terms increase rather than reduce loss.

  1. AAccepting the dealer's own unsecured bonds as collateral to avoid a mismatch
  2. BTaking higher-quality, diversified collateral with a haircut sized to liquidation time and price volatilityCorrect
  3. CLengthening the repo to term to lock in the current rate
  4. DLowering the haircut to compensate for the dealer's downgrade

Explanation

The lender's loss depends on collateral value falling below the cash lent during liquidation. Diversified, high-quality collateral with an adequate haircut reduces this. Dealer's own bonds create wrong-way risk, term repo lengthens exposure, and a lower haircut reduces protection.

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