FRM Part II · FRM Exam Part II · Liquidity Risk
During a liquidity crisis, many leveraged institutions sell similar assets to meet margin calls, which depresses prices and triggers further margin calls. Which concept best describes this self-reinforcing mechanism between market and funding liquidity?
This is a liquidity spiral: price declines raise margins and haircuts, forcing leveraged institutions to sell assets, which pushes prices lower and tightens funding further. It links market liquidity and funding liquidity in a feedback loop.
- ALiquidity spiralCorrect
- BWrong-way risk
- CMaturity transformation
- DNetting efficiency
Explanation
In a liquidity spiral, falling asset prices tighten margins and haircuts, forcing sales that push prices down further. Wrong-way risk concerns exposure correlated with counterparty default. Maturity transformation is funding long assets with short liabilities, a source of vulnerability but not the feedback loop itself. Netting reduces exposures and does not amplify them.
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