AIM 1: Explain the interrelationship between funding liquidity risk and market liquidity risk.

1、Which of the following is an example of liquidity risk?

A) The bid-ask spread for an actively traded asset is close to zero. 
 
B) The daily trading volume for a stock is significantly higher than the daily trading volume for the average stock.
 
C) A firm issues new bonds upon the maturity of an older bond issue.
 
D) A financial institution does not have the cash to meet its capital withdrawals. 
 

The correct answer is D

Liquidity risk (funding related) refers to the risk that a financial institution will be unable to raise the cash necessary to roll over its debt, fulfill cash requirements of counterparties, or meet capital withdrawals. Note that a wide bid-ask spread would indicate high liquidity risk (trading-related), while a bid-ask spread close to zero indicates little liquidity risk. Also, high trading volume would tend to indicate lower liquidity risk (trading-related).

AIM 3: Discuss factors that impact an asset’s liquidation cost.

1、An asset’s liquidation cost is most likely to be lower:

A) the less complex the security.
 
B) the quicker the asset must be liquidated.
 
C) if the asset must be sold to a dealer as opposed to a centralized market.
 
D) the larger the position to be liquidated.

The correct answer is A

Complex securities may impart hesitancy on the buyer due to the lack of experience in pricing the asset. The quicker an asset must be liquidated, the larger the discount from fair value the firm must accept. A centralized market provides a greater degree of immediacy of execution. The larger the position, the more likely the asset sale is to depress the current price.

AIM 5: Calculate liquidity-adjusted VAR.

1、An increase in the bid-ask spread will have which of the following effects on the liquidity-adjusted VAR (LVAR)?

A) It will decrease the LVAR.
 
B) It may increase or decrease the LVAR.
 
C) It will have no effect on the LVAR.
 
D) It will increase the LVAR.

The correct answer is D

The larger the spread, the larger the calculated LVAR.

2、A $10 MM portfolio has a daily volatility of one percent. What is the daily liquidity-adjusted VAR (LVAR) for the portfolio at the 95 percent confidence level if the bid-ask spread is 0.25 percent?

A) $178,250.
 
B) $184,750.
 
C) $187,000.
 
D) $177,000.

The correct answer is D

VARP = (0.01)(1.645)($10 MM) = $164,500
LVARP = $164,500 + ($10 MM)(0.0025 / 2) = $177,000

3、A $10 MM portfolio has a daily volatility of 0.50 percent and a bid-ask spread of 0.05 percent. What is the daily liquidity-adjusted VAR (LVAR) for the portfolio at the 99 percent confidence level?

A) $118,800.
 
B) $116,300.
 
C) $2,576.
 
D) $112,576.
 

The correct answer is A

VARP = (0.005)(2.326)($10 MM) = $116,300

LVARP = $116,300 + ($10 MM)(0.0005 / 2) = $118,800