FRM Part II · FRM Exam Part II · Liquidity and Leverage
Which event is the clearest example of a market liquidity risk source feeding back into funding liquidity risk, producing a liquidity spiral?
A liquidity spiral occurs when falling asset prices lead lenders to raise margins and haircuts, forcing leveraged investors to sell assets, which pushes prices down further and tightens funding again in a self-reinforcing loop.
- AA bank's credit rating is unchanged while its deposits grow
- BFalling asset prices raise margins and haircuts, forcing leveraged investors to sell, which depresses prices furtherCorrect
- CA central bank lowers its policy rate, reducing the bank's funding cost
- DA firm issues long-term debt to lengthen its liability maturity
Explanation
In a liquidity spiral, price declines tighten funding terms through higher margins and haircuts. Leveraged investors then sell assets, pushing prices lower and tightening funding again. The other options do not describe a feedback loop between market and funding liquidity.
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