FRM Part II · FRM Exam Part II · Liquidity Risk Management
During market stress, a leveraged hedge fund faces higher margin requirements from its prime broker, forcing it to sell assets, which pushes prices lower and triggers further margin calls. Which concept best describes this interaction between funding and market liquidity?
This is a liquidity spiral. Tighter funding and margin requirements force asset sales, falling prices reduce collateral values and raise margins, and this forces more sales. It links funding liquidity and market liquidity into a self-reinforcing loop, unlike wrong-way risk, which involves exposure and default correlation.
- ALiquidity spiralCorrect
- BWrong-way risk
- CBasis risk
- DConvexity risk
Explanation
A liquidity spiral (Brunnermeier and Pedersen) arises when funding constraints force asset sales, which depress prices and tighten margins and funding further. Wrong-way risk concerns exposure correlated with counterparty default, not this loop.
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