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FRM Part II · FRM Exam Part II · Liquidity Risk

Which of the following is a recognised limitation of the constant-spread LVaR approach that adds half the spread times position value to VaR?

The constant-spread approach captures only the quoted spread and typically ignores price impact from the firm's own large trades, as well as the tendency for spreads to widen when returns are poor in stressed markets. It therefore likely understates liquidity risk when conditions deteriorate.

  1. AIt treats the spread as fixed or only mildly variable and ignores price impact from selling a large position and the correlation between spread and returns in stressed marketsCorrect
  2. BIt cannot be applied to any portfolio containing more than one security
  3. CIt excludes market risk entirely and measures only liquidity cost
  4. DIt assumes the liquidation horizon is infinitely long

Explanation

The simple spread add-on captures only the exogenous cost from the quoted spread. It omits endogenous liquidity, i.e. the price impact of the firm's own trades, and spreads tend to widen precisely when prices fall. The other options misstate the method.

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