FRM Part II · FRM Exam Part II · Liquidity Risk
Which statement best describes the main limitation of the constant-spread and exogenous-spread approaches to liquidity-adjusted VaR when applied to a very large position in a thinly traded bond?
The main limitation is that these methods treat the spread as exogenous and independent of trade size. They therefore ignore the endogenous price impact of a large sale in a thin market, which understates the true liquidation cost of a big position.
- AThey ignore the bid-ask spread entirely and only consider price volatility
- BThey treat the spread as independent of trade size, so they omit the price impact of the bank's own sellingCorrect
- CThey overstate liquidity risk because spreads tend to narrow in stressed markets
- DThey can only be applied to positions that are liquidated over more than ten days
Explanation
Exogenous-spread approaches treat the spread as given by the market, so liquidation size does not affect it. Large positions in thin markets move prices (endogenous liquidity), which these models miss. Spreads normally widen, not narrow, in stress.
Did you get it right without looking?
One question tells you little. A timed set on Liquidity Risk shows your real accuracy, how long you take and where you lose marks.
More Liquidity Risk questions
- A risk manager at a trading firm notes that standard 99% one-day VaR for a large position in a thinly traded bond is computed from mid-marke…
- A trader holds a position in a bond quoted at a bid of 98.40 and an ask of 98.60. Using the mid-price as the reference, what is the proporti…
- A bank runs a reverse liquidity stress test. Which describes its objective most accurately?
- During a stress, a bank plans to raise cash by selling a bond portfolio with a market value of USD 500 million. The treasurer assumes a 10% …
- A treasurer notes that the bank's LCR is 120% but its NSFR is 92%. Which interpretation and response is most appropriate?
- A bank has USD 600 million of liquid assets. Over a 30-day stress, it expects: retail deposit outflows of 8% of USD 2,000 million; wholesale…