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

A portfolio manager must sell a large block of a thinly traded stock. Selling the entire block immediately would move the price sharply against her, while spreading the sales over several days exposes her to price volatility. In an optimal liquidation framework, which pair of costs is being traded off?

Optimal liquidation trades off market impact cost against price risk. Selling quickly pushes the price against the seller, while selling slowly leaves the remaining position exposed to price volatility, so the best schedule balances these two effects over the liquidation horizon.

  1. AMarket impact cost against price risk (volatility) over the liquidation horizonCorrect
  2. BBid-ask spread against custody fees
  3. CFunding cost against credit spread
  4. DTransaction tax against management fees

Explanation

Optimal liquidation balances the market impact incurred by trading quickly against the price risk from holding the unsold position longer. Faster selling raises impact but reduces volatility exposure; slower selling does the reverse. The other pairs are not the core trade-off.

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