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

A fund manager notes that LVaR based on the exogenous-spread approach is being used to measure risk on a large position in a thinly traded bond. Which limitation is most relevant to this approach?

The exogenous-spread approach takes the spread as given regardless of order size, so it ignores the price impact of the fund's own large sale. For a big position in a thinly traded bond this understates liquidity risk.

  1. AIt ignores the price impact of the fund's own trades, so it understates liquidity risk for large positionsCorrect
  2. BIt double counts market risk because the spread is already in mid-price volatility
  3. CIt assumes the spread is perfectly correlated with returns of the position
  4. DIt can only be applied to exchange-traded equities

Explanation

The exogenous-spread approach treats the spread as given and independent of the trader's order size. For large positions in thin markets, selling moves the price (endogenous liquidity), which this method omits. The other options misstate the model.

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