FRM P2 Liquidity and Treasury Risk: practice questions with answers

Answer: A. 1. Market VaR = 50 × 1.8% × 2.326 = $2.0934m.
2. Liquidity cost = ½ × position × (mean spread + k × spread s.d.) = 0.5 × 50 × (0.40% + 3 × 0.15%) = 0.5 × 50 × 0.85% = $0.2125m.
3. LVaR = 2.0934 + 0.2125 = $2.31 million.

The half-spread reflects that positions are marked at mid but sold at the bid. In this example the liquidity add-on raises VaR by about 10%.

Answer: B. The Basel Committee's intraday liquidity monitoring tools, discussed by Venkat and Baird, suggest testing intraday positions under four scenarios:

1. Own financial stress: the bank suffers (or is believed to suffer) a stress event. Counterparties delay their payments to the bank and may reduce intraday credit lines, while the bank must still settle time-specific and critical payments on time. Its peak intraday liquidity need rises.
2. Counterparty stress: a major counterparty suffers a stress event and cannot make payments, so expected inflows do not arrive.
3. Customer bank's stress: a customer of a correspondent bank suffers stress, affecting the correspondent's flows and the credit it has extended.
4. Market-wide credit or liquidity stress: for example, a fall in the value or eligibility of collateral used to generate intraday liquidity.

In an own-stress scenario, the bank should assume it cannot rely on incoming payments to fund outgoing ones and should check that its reserves, central bank collateral and committed lines cover its peak intraday need.

Answer: B. For a taxable investor, the tax-equivalent (before-tax) yield of a tax-exempt bond is:

TEY = tax-exempt yield / (1 − t) = 3.40% / 0.79 = 4.30%, above 4.20%.

Equivalently, the corporate bond's after-tax yield is 4.20% × 0.79 = 3.32%, below the municipal's 3.40%. The break-even tax rate is 1 − 3.40/4.20 = 19.0%; above it, the municipal bond wins.

In bank investment portfolio management, tax-exempt securities are attractive only when the bank has taxable income to shelter, which is why banks shift between municipals and taxable securities as earnings change (a form of tax management). Rules limiting interest-expense deductions on funds carrying municipals reduce the advantage and were set aside here.

Answer: A. 1. Haircuts: Level 2A = 400 × 85% = 340; Level 2B = 60 × 50% = 30.
2. 15% Level 2B cap: the limits are 15/85 × (300 + 340) = 112.9 and 15/60 × 300 = 75; 30 is below both, so no adjustment.
3. 40% Level 2 cap: Level 2 may not exceed 2/3 × Level 1 = 2/3 × 300 = 200. Level 2 = 370, so 170 is excluded.
4. HQLA = 300 + 200 = 500, of which Level 2 is exactly 40%.
5. LCR = 500 / 450 = 111.1%.

The cap stops a bank meeting the LCR mainly with assets that may lose value or liquidity in stress.

Answer: B. Rose and Hudgins list the factors in choosing among non-deposit sources: relative cost, risk (interest rate risk and credit availability risk), the length of time the funds are needed, the size of the bank and its access to markets, and regulation.

- Overnight or very short needs (such as a reserve shortfall): federal funds purchased or repurchase agreements, which can be arranged within the day and repaid tomorrow.
- Longer-term needs, especially for fixed-rate assets: term borrowing such as Federal Home Loan Bank advances (available at fixed rates and long maturities against eligible collateral) or term debt, which match the maturity and rate profile of the assets.
- Central bank discount window: a backstop for short-term liquidity needs, not a routine source of term funding.

Funding long-term fixed-rate assets with continually rolled short-term money creates repricing (interest rate) risk and rollover (availability) risk, the mismatch that ALM is designed to control.

Answer: C. Sound liquidity stress testing (as set out in the BCBS Principles for Sound Liquidity Risk Management and Supervision) uses a range of idiosyncratic, market-wide and combined scenarios, several time horizons (including intraday and days to months), conservative behavioural assumptions for deposits, wholesale funding, contingent commitments and collateral, and realistic stressed values for liquid assets. Assumptions should be challenged and updated with experience: the 2023 US regional bank failures showed that uninsured, concentrated deposits can run within hours. Results should feed into limits, the size of the liquidity buffer and the contingency funding plan.