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

A risk committee notes that its LVaR model adds a spread cost that is independent of trade size. Which limitation does this most directly expose?

A size-independent spread cost captures only exogenous liquidity and ignores endogenous liquidity, where a large sale moves prices against the seller. The model therefore understates liquidation costs for large or concentrated positions.

  1. AIt ignores endogenous liquidity, where larger trades move prices against the sellerCorrect
  2. BIt double counts the mid-price volatility
  3. CIt cannot be applied to equities
  4. DIt assumes spreads are negative in stress

Explanation

A spread cost that is independent of trade size reflects exogenous liquidity only. It omits endogenous liquidity risk, where selling large blocks pushes prices down, so the model can understate costs for concentrated positions.

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