THE CEO OF A REGIONAL BANK UNDERSTANDS THAT FAILING TO ANTICIPATE C...

1.

The CEO of a regional bank understands that failing to anticipate cash flow needs is one of the most serious

errors that a firm can make and demands that a good liquidity-at-risk (LaR) measurement system be an

essential part of the bank's risk management framework. Which of the following statements concerning LaR

is correct?

a.

Reducing the basis risk through hedging decreases LaR.

b.

Hedging using futures has the same impact on LaR as hedging using long option positions.

c.

For a hedged portfolio, the LaR can differ significantly from the VaR.

d.

A firm's LaR tends to decrease as its credit quality declines.

Correct Answer: c

Rationale:

The LaR can differ substantially from the VaR in a hedged portfolio, and in different situations can be

larger or smaller than the VaR. For example, consider a portfolio where futures contracts are used to hedge. While

the hedge can reduce the VaR of the portfolio, the LaR can be larger than the VaR as the futures contracts create

an exposure to margin calls and the potential for cash outflows. Alternatively, in situations where the hedging

instruments do not result in potential cash outflows over the measurement period (e.g. a portfolio of European

options which do not expire during the period), the LaR can be smaller than the VaR.

Section: Operational and Integrated Risk Management

Reference:

Kevin Dowd, Measuring Market Risk, Chapter 14, “Estimating Liquidity Risks.”

Learning Objective:

Describe liquidity at risk (LaR) and compare it to VaR, describe the factors that affect future

cash flows, and explain challenges in estimating and modeling LaR.

2015 Financial Risk Manager (FRM®) Practice Exam