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FRM Part II · FRM Exam Part II · Liquidity Risk Management

Which statement best describes the interaction between funding liquidity and market liquidity during a stress episode?

Funding and market liquidity reinforce each other. Funding stress forces asset sales that push prices down, and lower prices reduce collateral values and raise haircuts, which tightens funding further. This feedback loop is called a liquidity spiral.

  1. AThey are independent, so stress in one has no effect on the other
  2. BFunding constraints can force asset sales that depress prices, and falling asset prices reduce collateral values and tighten funding, creating a liquidity spiralCorrect
  3. CMarket liquidity improves when funding liquidity deteriorates because more sellers add depth
  4. DFunding liquidity depends only on a firm's equity capital and not on market conditions

Explanation

The liquidity spiral links the two: margin calls and funding stress cause fire sales, lower prices cut collateral values and raise haircuts, and funding tightens further. The other options deny or reverse this feedback.

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