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

Which statement best describes procyclical leverage among financial intermediaries that manage leverage actively using VaR-based or mark-to-market constraints?

Leverage is procyclical: when prices rise, equity grows and leverage falls, so intermediaries add assets using debt; when prices fall they sell assets to cut leverage. This amplifies booms and busts in asset prices and credit supply.

  1. AThey tend to expand balance sheets in booms and shrink them in downturns, amplifying asset price movementsCorrect
  2. BThey tend to shrink balance sheets in booms and expand them in downturns, stabilising prices
  3. CTheir leverage is unrelated to asset price changes
  4. DThey hold leverage constant by never trading

Explanation

When asset prices rise, measured equity increases and leverage falls, so intermediaries borrow to buy more assets, pushing prices up. In downturns the process reverses. Option B describes countercyclical behaviour.

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