FRM Part II · FRM Exam Part II · Liquidity Risk Management
During a market stress event, many leveraged funds with similar positions face margin calls and sell the same assets, pushing prices down and triggering further margin calls. Which concept best describes why a single firm's VaR based on exogenous liquidity assumptions understates risk in this situation?
Endogenous liquidity explains the understatement. When many participants with similar positions sell at once, their own trading depresses prices and triggers further margin calls, creating feedback loops. VaR assuming exogenous, fixed spreads ignores this amplification, so it understates losses in stress.
- AEndogenous liquidity: the firm's and others' collective trading actions move prices, creating feedback loopsCorrect
- BExogenous liquidity: bid-ask spreads are fixed by the market regardless of trade size
- CBasis risk between the hedge and the position
- DSettlement risk from delayed delivery
Explanation
Endogenous liquidity arises from the actions of market participants, including crowded selling and fire sales, which amplify price moves. Exogenous liquidity treats spreads as given, so VaR built on it ignores the feedback loop. Hence the standard VaR understates risk in crowded stress.
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