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FRM Part II · FRM Exam Part II · Monitoring Liquidity

A bank's stress test assumes it can raise USD 300 million by selling a bond portfolio with a market value of USD 300 million within five days. During the 2020-style market stress, bid-ask spreads for these bonds widened sharply and dealers' balance sheet capacity fell. Which critique of the test's assumption is most valid?

The assumption is flawed because it ignores the interaction between market and funding liquidity. Under stress, wider spreads and reduced dealer capacity mean sales realize less than market value and take longer, so the test should apply stressed haircuts and realistic liquidation timing.

  1. AIt ignores that market liquidity and funding liquidity risk interact, so haircuts and sale timing should be increased under stressCorrect
  2. BIt should assume no sales are possible at any horizon
  3. CIt is conservative because stressed prices rise as investors seek safety for all bonds
  4. DIt is valid because market value equals cash proceeds in any environment

Explanation

In stress, funding and market liquidity reinforce each other: spreads widen, depth falls and forced sales realize less than market value. The test should apply stressed haircuts and realistic timing. Assuming no sales at all is overly extreme, and the claim that prices rise is not true for these bonds.

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