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

A trader holds a large position in a thinly traded corporate bond and argues that because the bid-ask spread is stable, the exogenous spread approach fully captures liquidity risk. Which critique is most valid?

The key weakness is that the exogenous spread approach ignores endogenous liquidity: a large sale itself pushes prices down beyond the quoted spread. Liquidity cost therefore rises with position size in thin markets, so a stable quoted spread understates the true liquidation cost.

  1. AThe approach overstates risk because spreads always narrow in a crisis
  2. BThe approach ignores endogenous liquidity, since selling a large position moves prices against the seller beyond the quoted spreadCorrect
  3. CThe approach double counts market risk because it uses the VaR confidence level twice
  4. DThe approach cannot be applied to positions with positive expected return

Explanation

Exogenous approaches treat liquidity cost as independent of the trader's own trade size. For large positions in thin markets, own-trade price impact (endogenous liquidity) adds cost beyond the quoted spread. Spreads tend to widen, not narrow, in crises, so option A is wrong.

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