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FRM Part II · FRM Exam Part II · Liquidity Risk

A risk manager at a trading firm notes that standard 99% one-day VaR for a large position in a thinly traded bond is computed from mid-market prices. Which statement best describes why a liquidity-adjusted VaR (LVaR) is needed?

LVaR is needed because mid-price VaR assumes the position can be sold at the mid-market price. In reality, liquidating a large position in an illiquid market incurs bid-ask spread costs and price impact, so the true potential loss is larger than standard VaR shows.

  1. AMid-price VaR ignores the cost of unwinding the position, which includes bid-ask spread and market impactCorrect
  2. BMid-price VaR overstates risk because it ignores the benefit of the bid-ask spread
  3. CMid-price VaR is invalid because it assumes returns are normally distributed
  4. DMid-price VaR cannot be computed for bonds with fewer than 250 daily observations

Explanation

Standard VaR values the position at mid prices and assumes it can be liquidated at that price. LVaR adds the cost of liquidation, namely the spread and any price impact from selling a large position. The distribution assumption is a separate issue and not the reason for liquidity adjustment.

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