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

During a market shock, a dealer bank facing falling collateral values and rising haircuts sells assets quickly to meet margin demands. Which describes the resulting dynamic that can amplify the stress system-wide?

Fire sales lower asset prices and weaken collateral values, so lenders raise haircuts and demand more margin. That forces further asset sales and deleveraging, creating a self-reinforcing spiral that spreads stress across the system.

  1. AFire sales depress asset prices, raising haircuts and triggering further deleveragingCorrect
  2. BLower prices reduce haircuts, which restores funding capacity
  3. CTri-party clearing banks automatically absorb the losses
  4. DHigher repo rates attract stable long-term funding to the market

Explanation

Forced sales push prices down, which lowers collateral value and prompts lenders to raise haircuts, forcing more sales: a haircut-price spiral. Haircuts do not fall in such conditions, and clearing banks do not absorb these losses as a rule.

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