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FRM Part II · FRM Exam Part II · Liquidity Stress Testing

A risk manager reviews a liquidity stress test in which the buffer is composed mostly of one issuer's bonds and the survival horizon is reported as 45 days. Which concern is most relevant to the reliability of this result?

The key concern is that concentration in one issuer's bonds can increase haircuts and reduce market depth under stress, so the buffer may yield less cash than assumed. The reported 45-day survival horizon could therefore be overstated.

  1. AConcentration in one issuer may raise haircuts and reduce marketability under stress, so the buffer could be worth less than modelledCorrect
  2. BLong survival horizons always imply excessive funding costs
  3. CSurvival horizon cannot be computed for concentrated portfolios
  4. DIssuer concentration affects capital ratios but has no liquidity effect

Explanation

Concentrated buffers face wrong-way and market-depth risk: selling or repoing large amounts of one issuer's bonds in stress may require larger haircuts or price discounts. The modelled horizon may therefore be overstated. The other options are incorrect statements about horizons or concentration.

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