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FRM Part II · FRM Exam Part II · Liquidity Risk

In the Brunnermeier-Pedersen liquidity spiral, a trading firm hit by losses faces higher margins. Which sequence best describes the self-reinforcing mechanism?

The spiral runs from losses to reduced capital, then higher margins or haircuts, forced asset sales, lower prices, and renewed losses and margin increases. Funding liquidity and market liquidity reinforce one another, which makes the loop self-amplifying.

  1. ALosses reduce capital, higher margins force asset sales, prices fall, and further losses and margin increases followCorrect
  2. BHigher margins reduce volatility, which raises asset prices and restores capital
  3. CAsset sales raise prices because supply of cash increases, lowering margins
  4. DLosses raise the firm's creditworthiness, so lenders relax haircuts

Explanation

Losses erode capital and funding, lenders raise margins or haircuts, the firm must deleverage by selling assets, and the sales depress prices and volatility rises, causing more losses and still higher margins. The other options reverse the direction of at least one link.

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