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

A risk committee notes that during stress the bid-ask spreads on its holdings widen sharply and become highly correlated with market losses. What is the implication for LVaR estimated with a constant average spread?

LVaR based on a constant average spread is understated. In stress, spreads widen at the same time as prices fall, so liquidity costs and market losses are positively related in the tail. A fixed average spread misses this co-movement and underestimates true liquidation loss.

  1. ALVaR is overstated because spread costs are diversified away
  2. BLVaR is unaffected because spread cost is independent of market risk
  3. CLVaR is understated because liquidity cost and market loss are positively related in stressCorrect
  4. DLVaR becomes equal to ordinary VaR

Explanation

When spreads widen precisely when prices fall, liquidity cost and market loss occur together. A constant average spread ignores this and understates tail loss. Simply adding the two components also tends to understate in this case, not overstate.

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