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FRM Part II · FRM Exam Part II · Liquidity and Leverage

A risk manager wants to adjust a 1-day 99% VaR for the cost of liquidating a position in a normal market using the constant-spread approach. Which input is most directly needed to compute this liquidity cost?

The constant-spread approach needs the proportional bid-ask spread applied to position value. Half the spread times the position gives the cost of exiting at the bid rather than the mid-price, and that cost is added to market VaR. Return volatility is already in the VaR figure.

  1. AThe bid-ask spread relative to the mid-price, applied to the position valueCorrect
  2. BThe standard deviation of the bid-ask spread over the past year only
  3. CThe volatility of the position's mid-price returns over the liquidation period
  4. DThe correlation between the position and the market index

Explanation

In the constant-spread approach, the liquidity cost equals half the proportional bid-ask spread times the position value, which is added to the VaR. Return volatility is already captured in the market VaR and does not give the exit cost. The spread standard deviation is needed only for the exogenous-spread approach, not the constant-spread one.

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