How could a bank’s hedging activities with futures contracts expose it to liquidity risk?

How could a bank’s hedging activities with futures contracts expose it to liquidity risk?
A . The futures hedge may not work due to the widening of basis which could result in a loss for the bank.
B . Prices may move such that a loss results on the hedge.
C . Since futures require margins which are settled every day, the bank could find itself scrambling for funds.
D . The bank could get exposed to liquidity risk since futures trade on an exchange.

View Answer

Answer: C

Explanation:

When a bank hedges with futures contracts, it needs to maintain margin accounts which are settled daily to reflect market changes:

Margin Calls: If the market moves against the position of the futures, the bank must add funds to the margin account to cover potential losses. This can create significant liquidity risk if large sums are needed quickly.

Daily Settlements: Futures markets require daily mark-to-market settlements which means that any adverse movement in prices necessitates immediate liquidity to meet the margin requirements.

Market Volatility: In times of high volatility, the daily margin requirements can be substantial, potentially causing a scramble for liquidity if the bank has not pre-arranged sufficient liquidity buffers.

Thus, the need for daily margin settlements exposes the bank to liquidity risk as it must be able to provide cash on short notice.

References: How Finance Works, relevant sections on liquidity risks in derivative markets??.