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

A risk manager adds a liquidity adjustment to a 1-day 99% VaR for a single equity position by including the cost of closing out at the bid rather than at the mid-price. Which statement best describes what this exogenous spread adjustment captures?

The exogenous spread adjustment captures the cost of selling at the bid instead of the mid-price, which is half the quoted bid-ask spread. It reflects market-wide liquidity at normal trade size, not the price impact of the firm's own large trades.

  1. AThe price impact created by the firm's own trading when it sells a large block
  2. BThe cost of crossing half the quoted bid-ask spread when liquidating at marketCorrect
  3. CThe probability that the counterparty fails before settlement
  4. DThe volatility of the mid-price over the liquidation horizon

Explanation

Exogenous liquidity cost is the cost of trading at the quoted bid or ask instead of the mid-price, which equals half the spread per unit. Own-trade price impact is endogenous liquidity risk and is not captured by a quoted spread.

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