FRM Part II · FRM Exam Part II · Liquidity and Leverage
During a market stress episode, dealers widen bid-ask spreads on corporate bonds and reduce inventories, while leveraged investors face margin calls. Which description best captures the mechanism linking funding liquidity and market liquidity in this episode?
Tighter funding forces dealers and leveraged investors to sell into thinner markets, widening spreads and lowering prices. Falling prices and higher volatility raise margins and haircuts, tightening funding further, which is the liquidity spiral linking funding and market liquidity.
- ATighter funding for dealers and leveraged investors forces asset sales into thinner markets, widening spreads, lowering prices and tightening margins further in a liquidity spiralCorrect
- BWider spreads increase dealer profits, which relaxes funding constraints and restores market liquidity quickly
- CMarket liquidity and funding liquidity are independent, so spread widening has no effect on margin requirements
- DMargin calls reduce selling pressure because investors retain assets, stabilizing prices
Explanation
Funding constraints force deleveraging, which pressures prices and raises volatility; higher volatility raises margins and haircuts, reinforcing the spiral. The other options ignore this feedback loop.
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