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FRM Part II · FRM Exam Part II · Liquidity Risk

During a market stress episode, a dealer's quoted bid-ask spreads on corporate bonds widen sharply and quoted depth falls. Which interpretation is most consistent with market liquidity theory?

Wider spreads and thinner depth in stress reflect higher inventory-holding and adverse-selection costs for dealers, who demand more compensation for providing immediacy. This raises transaction costs for investors rather than lowering them, and it is not simply a result of a change in the risk-free rate.

  1. ADealers face higher inventory and adverse-selection costs, so they demand greater compensation for providing immediacyCorrect
  2. BDealers are reducing spreads to attract more order flow
  3. CThe widening reflects only a rise in the risk-free rate
  4. DWidening indicates lower transaction costs for investors

Explanation

Spreads compensate dealers for order-processing, inventory-holding and adverse-selection costs. In stress, volatility and information asymmetry increase and balance sheet capacity falls, so spreads widen and depth declines. Wider spreads mean higher, not lower, transaction costs.

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