Liquidity and Leverage (FRM Part 2 2023 – Book 4 – Chapter 2)

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After completing this reading, you should be able to:
Differentiate between sources of liquidity risk, including balance sheet/funding liquidity risk, systematic funding liquidity risk, and transaction liquidity risk, and explain how each of these risks can arise for financial institutions.
Summarize the asset-liability management process at a fractional reserve bank, including the process of liquidity transformation.
Describe and hedge funds, particularly in stress situations.
Compare transactions used in the collateral market and explain risks that can arise through collateral market transactions.
Describe the relationship between leverage and the return profile of a firm, calculate leverage ratio, and explain leverage effect.
Explain the effect on a firm’s leverage and the balance sheet of the purchase of long equity positions on margin, entry into short sales, and trading in derivatives.
Explain methods for measuring and managing funding liquidity risk and transaction liquidity risk.
Calculate the expected transaction cost and the spread risk factor for a transaction, and calculate the liquidity adjustment to VaR for a position to be liquidated over some trading days.
Explain interactions between various types of liquidity risk and explain how liquidity risk events can increase systemic risk.

0:00 Introduction
2:46 Sources of Liquidity Risk
5:55 Asset Liability Management (ALM)
9:38 The Asset-Liability Management Process
13:07 Economics of the Collateral Markets
17:01 Types of Collateral Markets
19:24 Leverage Ratio
21:59 The Leverage Effect
24:06 Explicit vs. Implicit Leverage
24:41 Margin Loans and Leverage
27:03 Other Leveraged Positions
32:21 Characteristics of Market Liquidity
33:46 Expected Transactions Cost
37:26 Liquidity-adjusted Value at Risk (LVAR)
44:12 How Hedge Funds Manage Funding Liquidity Risk