FRM Part II · FRM Exam Part II · Liquidity and Leverage
During a market downturn, a trading firm finds that falling asset prices reduce the value of its collateral, which forces it to sell assets, which in turn pushes prices lower and tightens funding further. Which concept best describes this feedback process?
This is a liquidity spiral, where funding liquidity and market liquidity reinforce each other. Falling prices erode collateral and raise margins or haircuts, forcing asset sales that push prices down again, which tightens funding constraints further.
- ALiquidity spiral between market liquidity and funding liquidityCorrect
- BBasis risk between cash and futures positions
- CWrong-way risk in a single counterparty exposure
- DSettlement risk in a payment system
Explanation
Brunnermeier and Pedersen describe loss spirals and margin spirals in which funding constraints force asset sales, lowering prices and further tightening funding. Wrong-way risk and basis risk do not capture this mutual reinforcement of market and funding liquidity.
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