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Nicole Seaman

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Learning objectives: Discuss the process of liquidity transfer pricing (LTP) and identify best practices for the governance and implementation of an LTP process. Discuss challenges that may arise for banks during the implementation of LTP. Compare the various approaches to liquidity transfer pricing (zero cost, average cost, matched maturity marginal cost). Describe the contingent liquidity risk pricing process and calculate the cost of contingent liquidity risk.

Questions:

20.15.1. What is the primary (valid) reason that banks need proper liquidity transfer pricing (LTP)?

a. Because banks engage in maturity transformation
b. Because there is a lack of liquidity transformation products in the marketplace
c. Because the true economic cost of liquidity risk is approximately zero
d. Because markets are volatile; e.g., volatility 1-year LIBOR/Swap spread


20.15.2. In regard to the various approaches to liquidity transfer pricing (LTP), each of the following statements is true EXCEPT which is false?

a. The zero cost of funds approach to LTP is a poor practice because it views funding liquidity as free and funding liquidity risk as essentially zero
b. The pooled average cost of funds approach to LTP is likely to undercharge long-term assets and therefore promote unhealthy maturity transformation
c. The matched-maturity marginal cost of funds approach to LTP is best practice but does require the bank to update term liquidity premiums
d. The matched-maturity marginal cost of funds approach to LTP charges deposits as a use of funds but charges "sticky" deposits due to the expense of an adhesive agent


20.15.3. Suppose a line of credit (LOC) with a limit of $20.0 million has $6.0 million already drawn. Assume there is a 65.0% chance the customer will draw on the remaining credit. The bank's term liquidity premiums (over a five-year horizon) are shown here:




The line of credit (LOC)'s cost of funding the liquidity cushion presumes a three-year (3 year) term. What is the LOC's dollar charge for the cost of contingent liquidity risk?

a. $4,500
b. $9,000
c. $13,650
d. $25,950

Answers here:
 
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