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Examine how transactions in available assets change cash flows and the capacity to generate liquidity.

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

The idea

Transactions in available assets change both the cash flow profile and the capacity to generate liquidity. Selling an asset brings cash in today, but removes that asset's later coupons and principal from the ladder. So it brings cash forward rather than creating it. A repurchase agreement brings in cash equal to market value less the haircut today. It creates an outflow of that cash plus interest at the repo maturity. The pledged asset is encumbered and cannot be used again. Converting an asset to cash does not reduce overall capacity by the asset's full value, because the cash counts at face value. Capacity changes only by the difference in haircut or discount. The usual mistake is to double count both the asset and the cash, or to drop the cash.

A practice question

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

How does selling a liquid government bond for cash change the bank's cash flow ladder?

  1. It creates an outflow today and an inflow at maturityWhy not: Reverses the signs; a sale brings cash in now.
  2. It creates an inflow today equal to the sale proceeds and removes the bond's future coupons and principal from later buckets - correct
  3. It has no effect on the ladder because the bond stays on the balance sheet until maturityWhy not: Ignores that a sold bond leaves the balance sheet and its cash flows are removed.
  4. It creates an inflow today and keeps the bond's coupons and principal in later bucketsWhy not: Counts the bond's future cash flows even though the bank no longer owns the bond.

A sale accelerates cash. It brings proceeds forward and removes the asset's own future inflows, so it transfers liquidity in time rather than creating it.

A harder one

A bank repos government bonds with market value USD 200 million at a 4% haircut for one month at a repo rate of 2% per annum (simple interest, 1/12 of a year). It receives cash of USD 192 million today and repays the cash plus interest at maturity. What is the net effect on its cumulative net cash flow by the end of the one-month bucket?

  1. -0.32 (USD million) - correct
  2. +192.00 (USD million)Why not: Counts the inflow today and omits the repayment due within the one-month bucket.
  3. -8.33 (USD million)Why not: Calculates repayment on the market value of 200 rather than on the 192 of cash received.
  4. -192.32 (USD million)Why not: Counts only the repayment and leaves out the cash received today.

Repayment = 192 x (1 + 0.02/12) = 192.32. Net = +192 - 192.32 = -0.32. The repo is almost neutral over the bucket; it moves cash forward at the cost of interest.

The hardest tier

A bank holds government bonds worth USD 600 million (repo haircut 5%) and corporate bonds worth USD 400 million (haircut 20%). Its capacity is therefore USD 570 + 320 = USD 890 million. It repos USD 300 million of the government bonds and receives USD 285 million of cash, which it holds. Its liquidity generation capacity immediately afterwards, counting cash at face value, is:

  1. USD 605 millionWhy not: Counts the remaining bonds but omits the cash just received.
  2. USD 1,175 millionWhy not: Adds the cash to a capacity that already included the pledged bonds, double counting.
  3. USD 590 millionWhy not: Deducts the full market value of the collateral and credits no cash.
  4. USD 890 million - correct

After the repo: remaining government bonds 300 x 0.95 = 285, corporates 320, cash 285; total 890. The repo converts capacity into cash and leaves total capacity unchanged, although the repayment at maturity is a new obligation.

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