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Characterise liquidity options with examples, and show how they affect a bank's liquidity position and the way it manages liquidity.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Monitoring Liquidity · FRM2.LTR.7.b

The idea

A liquidity option is a right, embedded in a contract or granted to a client, that lets the holder decide whether and when a cash flow occurs. Examples a bank typically writes are committed credit lines, deposits that can be withdrawn early, loan prepayment rights, and collateral clauses triggered by a rating downgrade. When the bank is the writer, it is short the option. The holder exercises when it suits the holder, which is often when the bank is under stress and funding is hardest to find. The cash flow therefore becomes stochastic, expected-value planning understates the need, and the bank must hold liquid assets or limits against the exercise amount. A bank that buys a committed standby facility holds the option and gains capacity. Exam point: judge who holds the option, and size the buffer for stressed exercise, not average exercise.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is an example of a liquidity option written by a bank?

  1. A fixed-rate bond issued by the bank with no early redemption feature and a fixed coupon payable on set dates until maturityWhy not: Has no embedded right for the holder to change timing, so it is not an option.
  2. A scheduled instalment on a performing loan the bank has madeWhy not: Takes a contractual payment schedule for an option; no party can choose to change it.
  3. A committed credit line that lets a corporate client draw funds at its discretion up to an agreed limit - correct
  4. A term deposit that cannot be withdrawn before maturityWhy not: Without an early-withdrawal right there is no option; the cash flow is fixed.

A committed line gives the client the right to draw at its choice, so the bank is short a liquidity option. The other items have no discretionary right.

A harder one

A bank has granted a committed credit line with a limit of USD 500 million, of which USD 100 million is drawn. Historically, 10% of the undrawn amount is drawn in a month in normal times; in a stress scenario 40% of the undrawn amount is drawn. What additional monthly outflow does the stress scenario produce compared with normal conditions?

  1. USD 200 millionWhy not: Applies the stress rate of 40% to the full limit of 500 and ignores the normal-time drawdown.
  2. USD 120 million - correct
  3. USD 160 millionWhy not: Applies 40% to the undrawn 400 but does not deduct the 10% expected in normal times.
  4. USD 150 millionWhy not: Applies the 30 percentage point increase to the full limit instead of the undrawn amount.

Only the undrawn amount can be drawn: 400 x (40% - 10%) = 120. Stress exercise of the option is compared with its expected exercise.

The hardest tier

A depositor holds USD 100 of a one-year term deposit paying 3% interest at maturity. The deposit may be withdrawn at month 6 at par, with all accrued interest forfeited. The depositor can reinvest at a simple annual market rate r for the remaining six months. The market rate at which early withdrawal becomes worthwhile is closest to:

  1. 3.0%Why not: Compares r with the deposit rate and ignores the interest forfeited on early withdrawal.
  2. 1.5%Why not: Compares the six-month interest forgone with a six-month rate r without annualising it.
  3. 6.0% - correct
  4. 12.0%Why not: Doubles twice: annualises the 3% six-month break-even to 6% and then doubles it again.

Holding gives 100 x 1.03 = 103 at month 12. Withdrawing gives 100 x (1 + r/2). Break-even r/2 = 3%, so r = 6%. The forfeited accrued interest raises the exercise threshold above the deposit rate.

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