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FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

A hedge fund manager reviewing the fund's risk framework wants stress tests that capture the risk of a sudden, simultaneous loss of funding liquidity and asset liquidity. Which feature would make a stress-testing programme MOST useful for this purpose?

Scenarios linking redemptions, higher margin requirements and wider bid-ask spreads are most useful, because funding and asset liquidity shocks reinforce each other in a crisis. Stressing factors independently or assuming normal correlations understates combined losses and misses the feedback loops that drive liquidity spirals.

  1. AScenarios calibrated only to the worst daily return in the last year
  2. BScenarios that link redemptions, margin increases, and wider bid-ask spreads occurring togetherCorrect
  3. CScenarios that assume correlations stay at their long-run averages
  4. DScenarios that stress each risk factor independently while holding others constant

Explanation

Liquidity crises feature interacting shocks: investors redeem, prime brokers raise margin and haircuts, and asset liquidity deteriorates. A programme must model these jointly. Independent factor shocks or average correlations understate combined losses, and a one-year window may omit crisis conditions.

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