Financial Risk Manager Part 1
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Lehman Brothers, like many other financial institutions, relied heavily on the repo market for funding. A repo, or repurchase agreement, is a form of short-term borrowing for dealers in government securities. In a typical repo transaction, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. The difference in price is the dealer's overnight interest cost. Lehman Brothers was heavily reliant on these short-term funding sources, borrowing billions of dollars each day in the overnight wholesale funding markets to operate. This reliance on short-term funding was a significant factor in Lehman's collapse when the liquidity of these markets dried up during the financial crisis.
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Explanation:
Explanation
Correct Answer: B (Repo market)
Lehman Brothers' primary source of funding was the repo market (repurchase agreement market). This was a crucial vulnerability that contributed to their collapse during the 2008 financial crisis.
Why Repo Market was Primary Funding Source:
- Short-term borrowing: Repo agreements provided daily funding through overnight transactions
- Scale: Lehman borrowed billions of dollars daily in overnight wholesale funding markets
- Government securities: Used as collateral in these transactions
- Liquidity dependency: When repo market liquidity dried up during the crisis, Lehman couldn't roll over their funding
Why Other Options are Incorrect:
A. Bond market: While Lehman did use bond markets, this was not their primary funding source during the period leading up to the crisis. Bond market financing is typically more expensive and less flexible.
C. Stock sales: Equity issuance through stock sales was not a primary funding mechanism. This would dilute existing shareholders and is not suitable for daily operational funding needs.
D. Reserves: Reserves serve as buffers against unexpected losses, not as primary funding sources for ongoing operations in financial institutions.
Key Risk Management Lesson:
The heavy reliance on short-term repo funding created significant liquidity risk. When market confidence evaporated and counterparties refused to roll over repo agreements, Lehman faced immediate funding shortages that led to their collapse. This case highlights the importance of diversified funding sources and robust liquidity risk management.
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