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

A trader argues that ignoring spread risk is acceptable because the average spread is small. Which is the strongest reason a liquidity-adjusted VaR should use a stressed spread rather than only the average spread?

A stressed spread is needed because bid-ask spreads tend to widen in market stress, exactly when price losses are large and positions must be liquidated. The average spread therefore understates the liquidation cost in the tail scenarios that VaR is meant to capture.

  1. ASpreads are constant over time, so the mean is exact
  2. BSpreads tend to widen in market stress, coinciding with large price lossesCorrect
  3. CSpreads and mid-prices are perfectly negatively correlated
  4. DThe average spread already includes the firm's own price impact

Explanation

Spreads widen during stress, precisely when losses are large, so the average understates the cost of liquidation in the tail. The other options are false: spreads are not constant, and the average spread excludes own price impact.

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