FRM Part II · FRM Exam Part II · Liquidity Risk
Which mechanism best explains a liquidity spiral in which falling asset prices and tightening funding reinforce each other?
A liquidity spiral arises when higher margins and haircuts force leveraged investors to sell assets. The sales depress prices, causing further losses and still higher margins, so market liquidity and funding liquidity reinforce each other in a self-amplifying loop.
- AHigher margins and haircuts force leveraged investors to sell assets, which lowers prices and further raises marginsCorrect
- BLower volatility reduces margin requirements, encouraging more buying and higher prices
- CCentral bank asset purchases reduce funding costs and stabilise collateral values
- DDiversification of funding sources reduces rollover concentration and lowers prices
Explanation
In the Brunnermeier-Pedersen framework, losses and rising volatility tighten margins and haircuts, forcing deleveraging and asset sales. Those sales depress prices, creating further losses and higher margins. The other options describe stabilising or unrelated effects.
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