FRM Part II · FRM Exam Part II · Monitoring Liquidity
During a market-wide stress, a bank finds that its funding sources dry up at the same time as the assets it planned to sell lose value and become hard to trade. Which concept best describes this interaction?
This is the interaction of funding and market liquidity risk, a liquidity spiral. Tight funding forces asset sales, falling prices and wider spreads reduce market liquidity, and this in turn further impairs funding. Credit, basis and settlement risk do not describe this reinforcing feedback.
- AThe interaction of funding and market liquidity risk, creating a liquidity spiralCorrect
- BPure credit risk arising from borrower default
- CBasis risk from imperfect hedging
- DSettlement risk from failed trades
Explanation
When funding tightens, institutions sell assets, which depresses prices and reduces market liquidity, further worsening funding conditions. This reinforcing feedback is a liquidity spiral. The other options are different risk types.
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