FRM Part II · FRM Exam Part II · Liquidity and Leverage
Which statement best describes why endogenous liquidity risk is not captured by a VaR adjustment that uses a fixed bid-ask spread?
A fixed-spread adjustment assumes trades execute at quoted prices, but a large sale by the bank itself moves prices against it. This endogenous price impact makes true liquidation costs higher than the quoted spread implies.
- AThe bank's own large trades can move prices and widen the effective spread beyond the quoted levelCorrect
- BFixed spreads overstate costs when positions are small
- CEndogenous risk only arises from changes in interest rates
- DQuoted spreads already include the price impact of any order size
Explanation
Quoted spreads apply to small trades. When a position is large relative to market depth, selling it moves the price against the seller, so the true cost exceeds the fixed-spread estimate. This price impact is endogenous to the bank's own action.
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