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

A fund holds a position with a mid-price of 50.00 and a quoted bid-ask spread of 0.40. The position is 200,000 units, and the daily 99% price VaR is 1,500,000 using mid-prices. Using the simple liquidity-adjusted VaR approach that adds half the spread as an exogenous liquidity cost (cost = 0.5 x position value x relative spread), what is the liquidity-adjusted VaR?

The liquidity-adjusted VaR is 1,540,000. Position value is 10 million, the relative spread is 0.8%, and half-spread cost is 40,000. Adding this to the 1,500,000 mid-price VaR gives 1,540,000. Using the full spread would wrongly double the liquidity cost.

  1. A1,540,000Correct
  2. B1,500,000
  3. C1,580,000
  4. D1,700,000

Explanation

Position value = 200,000 x 50 = 10,000,000. Relative spread = 0.40/50 = 0.8%. Cost = 0.5 x 10,000,000 x 0.008 = 40,000. LVaR = 1,500,000 + 40,000 = 1,540,000. Using the full spread would give 1,580,000, which overstates the cost of liquidating at the bid.

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