FRM Part II · FRM Exam Part II · Liquidity and Leverage
During a stress episode, a trader notes that bid-ask spreads on a corporate bond widen sharply while quoted depth shrinks. Which interpretation best fits this observation in terms of the dimensions of market liquidity?
Wider spreads mean tightness has worsened, and smaller quoted size means depth has worsened. Together they indicate lower market liquidity. Resilience, the speed at which prices recover after trades, is a separate dimension that spreads do not measure directly.
- ABoth tightness and depth have deteriorated, indicating lower market liquidityCorrect
- BTightness has improved but resilience has deteriorated
- CDepth has improved because dealers are quoting wider prices
- DOnly resilience is affected, since spreads measure the speed of price recovery
Explanation
Tightness is measured by the bid-ask spread, and wider spreads mean worse tightness. Depth is the size that can be traded near the quote, and shrinking quotes mean worse depth. Resilience concerns how fast prices recover after a shock and is not what spreads directly measure.
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