Explanation:
Liquidity-adjusted VaR (L-VaR) incorporates the cost of liquidating a position. The constant spread approach assumes the bid-ask spread remains constant, so the liquidity cost added to VaR is simply half the average spread multiplied by the position size. The exogenous approach assumes the spread is a random variable, adding a confidence interval for the spread (average spread + Z * spread volatility) to the VaR. Because the exogenous approach incorporates spread volatility, it typically results in a higher L-VaR. Therefore, the desk reporting the lower L-VaR (Manchester) is most likely using the constant spread approach.
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Q.6 A financial manager in the U.K noticed that the liquidity-adjusted VaR that was being reported by the sovereign debt trading desk in Manchester was lower than that reported by the sovereign debt trading desk in London, even on identical bond holdings. Which liquidity measurement approach does the debt trading desk in Manchester most likely use?
A
The exogenous approach
B
The constant spread approach
C
The bid-ask spread approach
D
Both the exogenous approach and the constant spread approach
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