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FRM Part II · FRM Exam Part II · Liquidity Risk Management

A bank's LVaR model assumes spreads are exogenous and independent of trade size. A desk plans to liquidate a position equal to 40% of average daily volume in an illiquid bond. Which is the most appropriate conclusion?

LVaR is likely understated. The exogenous-spread model ignores endogenous liquidity, so a sale equal to 40% of daily volume would push prices down and widen effective spreads beyond the quoted half-spread, creating costs the model does not capture.

  1. ALVaR is likely understated because the order itself would likely widen the effective spread and move pricesCorrect
  2. BLVaR is overstated because large trades receive tighter quotes
  3. CLVaR is accurate because half-spread captures all liquidation costs
  4. DLVaR is irrelevant because the market VaR already covers trade size

Explanation

Exogenous-spread LVaR ignores endogenous liquidity risk: a large order relative to market depth moves prices and costs more than the quoted half-spread. Large trades do not usually get tighter quotes.

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