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

A risk manager is designing a liquidity stress test for a bank. Which design feature would most improve the realism of a combined market and funding liquidity stress scenario?

The best feature is modelling the feedback between market and funding liquidity. Falling prices trigger higher haircuts and margin calls, forcing asset sales that push prices lower again. Assuming independence, average spreads or guaranteed rollover ignores this spiral and understates stressed liquidity needs.

  1. AAssume asset haircuts and funding outflows are independent so that scenario effects can be summed separately
  2. BModel the interaction in which falling asset values raise margin and collateral calls, which forces asset sales and further price fallsCorrect
  3. CUse only historical average bid-ask spreads to calibrate asset liquidation costs
  4. DAssume the bank can roll over all secured funding because collateral is high quality

Explanation

Market and funding liquidity reinforce each other through liquidity spirals: price declines raise haircuts and margin calls, forcing sales that depress prices. Assuming independence, average spreads or full rollover understates stress and ignores these feedback loops.

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