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FRM Part II · FRM Exam Part II · Liquidity Risk

Which of the following is the most accurate description of how bid-ask spreads typically behave when a market moves into stress, and the implication for risk measurement?

In stress, spreads typically widen, become more volatile and move together across assets as dealers withdraw balance-sheet capacity. A constant-spread liquidity adjustment therefore understates liquidation costs exactly when losses are largest, so stressed or time-varying spread assumptions are needed.

  1. ASpreads tend to widen and become more volatile and correlated across assets, so a constant-spread LVaR can understate liquidation costsCorrect
  2. BSpreads tend to narrow as dealers compete for volume, so constant-spread LVaR overstates liquidation costs
  3. CSpreads remain stable because they are set by exchange rules, so no liquidity adjustment is needed
  4. DSpreads widen only for illiquid assets and are uncorrelated with market returns, so diversification of liquidity cost is reliable

Explanation

In stress, dealers face inventory and funding constraints and adverse selection rises, so spreads widen, become more variable, and move together across assets. Liquidity costs therefore have a positive correlation with market losses, and constant-spread assumptions understate them.

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