Skip to content

FRM Part II · FRM Exam Part II · Liquidity and Leverage

A portfolio manager notes that during stress, a position's bid-ask spread widens sharply and the position is large relative to market depth, so selling pushes prices down. Which statement best describes why a constant-spread LVaR is inadequate here?

Constant-spread LVaR treats the spread as fixed and ignores that a large sale moves the price. In stressed markets spreads widen and the seller's own trading creates endogenous price impact, so the approach understates liquidation cost.

  1. AIt ignores both spread widening in stress and the endogenous price impact of the manager's own sellingCorrect
  2. BIt overstates liquidity cost because spreads normally narrow when volatility rises
  3. CIt double counts market risk because VaR already includes the bid-ask spread
  4. DIt applies only to derivatives, not to cash securities

Explanation

Constant-spread LVaR assumes a fixed spread and no price impact from the trade. In stress spreads rise and a large position moves the price against the seller (endogenous liquidity). The other statements are incorrect: spreads typically widen with volatility and VaR based on mid-prices excludes spread costs.

Did you get it right without looking?

One question tells you little. A timed set on Liquidity and Leverage shows your real accuracy, how long you take and where you lose marks.

Practise Liquidity and LeverageFree diagnostic mock

More Liquidity and Leverage questions