FRM Part II · FRM Exam Part II · Monitoring Liquidity
Which feature most clearly explains why liquidity risk can be self-reinforcing in a market-wide stress?
Liquidity risk is self-reinforcing because falling prices trigger margin calls and higher haircuts, forcing leveraged holders to sell assets, which pushes prices down again. This loop links market liquidity and funding liquidity and amplifies stress across institutions.
- AFalling asset prices cause margin calls and forced sales, which push prices lower stillCorrect
- BBanks hold too much central bank reserve cash
- CInterest rate curves become perfectly flat
- DEquity capital ratios rise automatically
Explanation
Liquidity spirals arise when price declines tighten margin and haircuts, forcing deleveraging and sales that depress prices further. The other options do not describe a feedback loop that links funding and market liquidity.
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