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

A risk manager compares two portfolios with identical market VaR. Portfolio X holds liquid large-cap equities with stable spreads. Portfolio Y holds emerging-market bonds whose spreads widen sharply and become more volatile in stress. Under the exogenous-spread LVaR approach, why will Y's LVaR add-on be much larger than X's?

Y's add-on is larger because the exogenous-spread formula depends on the mean spread plus a multiple of spread volatility. Y has both a wider and more volatile spread, so its stressed half-spread liquidation cost is much higher, even with identical market VaR.

  1. ABecause its spread volatility term and mean spread are higher, increasing the stressed half-spread costCorrect
  2. BBecause the approach assumes Y's trades move the market price against the seller
  3. CBecause market VaR is reduced when spreads are volatile
  4. DBecause the holding period must be longer for bonds by regulation

Explanation

The add-on is half the mean spread plus a multiple of spread volatility times position value, so higher mean and volatility of spreads raise it. Price impact of own trades belongs to endogenous models, not this approach.

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