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Answer: If market liquidity decreases, the liquidity horizon will lengthen, and the credit risk exposure will increase.
## Explanation When market liquidity decreases: - **Liquidity horizon lengthens**: In illiquid markets, it takes longer to exit positions without significantly impacting prices, so the time required to liquidate positions (liquidity horizon) increases. - **Credit risk exposure increases**: During periods of low market liquidity, counterparties may face difficulties meeting their obligations, and the ability to hedge or transfer risk becomes more challenging, leading to higher credit risk exposure. This relationship is fundamental in risk management: - Decreased liquidity → Longer time to liquidate → Extended exposure period → Higher credit risk - The opposite is also true: increased market liquidity shortens the liquidity horizon and decreases credit risk exposure.
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A quantitative risk analyst at a bank has been asked to incorporate market liquidity into the bank's VaR model. The analyst examines how changes in the level of market liquidity impact the liquidity horizon and the bank's credit risk exposure. Which of the following statements describes the most likely impact of changes in market liquidity?
A
If market liquidity decreases, the liquidity horizon will shorten, and the credit risk exposure will increase.
B
If market liquidity decreases, the liquidity horizon will lengthen, and the credit risk exposure will increase.
C
If market liquidity increases, the liquidity horizon will shorten, and the credit risk exposure will increase.
D
If market liquidity increases, the liquidity horizon will lengthen, and the credit risk exposure will decrease.
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