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FRM Part II · FRM Exam Part II · Liquidity and Reserves Management: Strategies and Policies

A treasurer holds USD 500 million of a corporate bond in the liquidity buffer. Under the bank's stress policy the bond carries a 20% haircut. The bank needs the buffer to deliver USD 800 million of liquidity from this bond and cash combined, and holds USD 450 million of cash. How much market value of the bond is needed to cover the shortfall?

The bank needs USD 437.5 million of bond market value. The liquidity shortfall is 350 million after cash, and a 20% haircut means each dollar yields 80 cents, so 350 divided by 0.8 equals 437.5 million. Simply adding 20% would understate the requirement.

  1. AUSD 350.0 million
  2. BUSD 437.5 millionCorrect
  3. CUSD 420.0 million
  4. DUSD 280.0 million

Explanation

Shortfall = 800 - 450 = 350 million of liquidity. With a 20% haircut each unit of market value gives 0.8, so required market value = 350 / 0.8 = 437.5. Ignoring the haircut gives 350, and 350 x 1.2 = 420 wrongly grosses up by multiplication.

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