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FRM Part II · FRM Exam Part II · Liquidity and Leverage

Which statement best describes how leverage affects a fund's risk when the fund's lenders can adjust margin requirements?

Rising asset volatility can lead lenders to raise margins and haircuts, forcing leveraged investors to sell assets. The forced selling depresses prices further, creating a feedback loop in which leverage links market liquidity and funding liquidity and amplifies losses.

  1. ALeverage only scales returns proportionally and does not create liquidity risk
  2. BRising asset volatility can raise margins, forcing deleveraging that amplifies price declinesCorrect
  3. CLeverage reduces risk because borrowed funds diversify the equity base
  4. DMargin requirements are independent of market volatility, so leverage stays stable

Explanation

Margins and haircuts tend to rise when volatility rises, so leveraged investors must sell assets, pushing prices down further and creating a loss spiral. Proportional scaling of returns ignores this funding liquidity channel.

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