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FRM Part II · FRM Exam Part II · Liquidity and Leverage

During a market stress episode, dealers raise haircuts on repo collateral across many asset classes simultaneously. Which outcome best describes the resulting leverage and liquidity dynamic for leveraged investors?

Higher haircuts reduce the leverage investors can sustain, forcing them to sell assets. Those sales push prices down and raise volatility, which tends to trigger still higher haircuts and margins. This reinforcing loop is the margin or liquidity spiral that links funding liquidity to market liquidity.

  1. AHigher haircuts lower required equity per unit of assets, so leverage can rise safely
  2. BHigher haircuts cut maximum leverage, forcing asset sales that depress prices and tighten funding conditions furtherCorrect
  3. CHigher haircuts affect only unsecured funding and leave asset prices unchanged
  4. DHigher haircuts reduce margin spirals because they decrease collateral values uniformly

Explanation

Higher haircuts raise the equity needed per unit of assets, reducing feasible leverage. Investors with fixed capital must deleverage by selling, which pushes prices down, increasing volatility and haircuts further in a loss or margin spiral. The first option reverses the relationship.

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