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FRM Part II · FRM Exam Part II · Liquidity Risk

A risk manager at a trading desk notes that standard 99% one-day VaR for a large position in a thinly traded bond uses mid-market prices. Which statement best describes the main purpose of adding a liquidity adjustment to this VaR?

A liquidity adjustment adds the cost of unwinding a position, such as crossing the bid-ask spread, to standard VaR. Ordinary VaR assumes liquidation at mid prices without cost, so it understates loss for illiquid positions. The adjustment captures that exit cost rather than changing volatility, horizon or correlations.

  1. ATo capture the cost of exiting the position at bid prices, rather than at mid prices, given the market's bid-ask spreadCorrect
  2. BTo reduce the volatility estimate by using a longer historical window
  3. CTo convert the VaR from a one-day horizon to a ten-day horizon using the square-root-of-time rule
  4. DTo remove the effect of correlations between the bond and other positions

Explanation

Standard VaR values positions at mid prices and assumes they can be liquidated without cost. Liquidity-adjusted VaR adds the cost of unwinding, such as half the bid-ask spread, and possibly market-impact effects. The other options concern volatility estimation, horizon scaling or diversification, not liquidity cost.

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