## **Learning Outcomes**

This article explains how liquidity risk arises in trading and financing activities, why it becomes most severe during market stress, and how it affects valuation and risk measures. After reading, you will be able to:

- Distinguish market liquidity risk from funding liquidity risk and describe common drivers of each
- Explain how collateral, haircuts, and margining connect funding conditions to asset prices
- Adjust common risk measures (e.g., VaR and ES) and stress tests to reflect illiquidity and liquidity feedback effects

## **GARP FRM Part 1 Syllabus**

For the GARP FRM Part 1 exam, you are expected to understand liquidity risk and balance-sheet financing risk with a focus on the following syllabus points:

- Differences between market liquidity risk and funding liquidity risk, including typical triggers and indicators
- How illiquidity affects valuation, risk measurement (VaR/ES), and model assumptions such as liquidation horizons
- The role of scenario analysis and stress testing governance in assessing capital and liquidity adequacy

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which statement best describes **market liquidity risk**?  
   a) The risk that a borrower will not repay principal and interest  
   b) The risk that a firm cannot meet cash outflows when due  
   c) The risk that positions cannot be traded quickly without large price concessions  
   d) The risk that interest rates move against an existing position

2. A \$100 million bond position is financed in the repo market with a 5% haircut. The haircut increases to 12% while the bond price is unchanged. How much additional cash collateral is required?

3. In one or two sentences, describe a “liquidity spiral” and name the two types of liquidity involved.

4. True/False (brief explanation required): A 1-day 99% VaR remains appropriate for a position even if it would take 10 trading days to liquidate it under stressed conditions.

## **What Do You Know Already?**

- Can you explain, without notes, how bid-ask spreads and market depth relate to market liquidity?
- Do you know how haircuts and margin calls create funding pressure during volatility spikes?
- Can you state at least two ways illiquidity can cause VaR/ES to understate risk?

Use these prompts to gauge your starting point; then focus your revision where your answers were least confident.

## **Introduction**

Liquidity is often described as “the ability to transact,” but for risk managers it has two distinct meanings: (1) the ability to trade positions at or near observable prices, and (2) the ability to obtain cash (or cash-like funding) to meet obligations such as margin calls, withdrawals, and debt maturities. The 2007–2009 crisis and later stress episodes showed that both can disappear quickly and, even more importantly, can feed into one another.

For FRM Part 1, liquidity sits at the intersection of valuation, market risk measurement, and stress testing. Many standard risk models assume that positions can be rebalanced or liquidated within a fixed holding period (e.g., 1 day or 10 days) at prices consistent with recent observations. When liquidity deteriorates, these assumptions fail: liquidation horizons lengthen, transaction costs rise, correlations jump, and funding terms tighten at the same time that prices move adversely.

> **Key Term: Liquidity risk**  
> The risk that a firm cannot execute transactions at reasonable prices (market liquidity risk) or cannot meet cash and collateral obligations when due (funding liquidity risk).

## **Market Liquidity Risk**

Market liquidity risk is the risk of loss arising from the need to trade in a market that cannot absorb the trade size without a large price concession. The loss is not primarily from “fundamental value” changes, but from the mechanics of trading: transaction costs, market impact, and delays.

### Core elements of market liquidity

A practical way to describe market liquidity is through three observable features:

1. **Tightness**: low transaction costs (narrow bid-ask spreads).
2. **Depth**: large quantities available at or near the current price (thick order book, high volumes).
3. **Resiliency**: prices recover quickly after trades (temporary impact dissipates).

When liquidity is poor, trades “move the market,” spreads widen, and execution prices become uncertain.

> **Key Term: Bid-ask spread**  
> The difference between the best available ask price and bid price. It is a direct measure of trading cost; wider spreads indicate lower market liquidity.
>
> **Key Term: Market impact**  
> The adverse price movement caused by executing a trade. Market impact typically increases with trade size relative to typical market volume and with market stress.

### Typical drivers of market illiquidity

Market liquidity can decline for reasons that are not about the traded asset’s long-term cash flows:

- **Dealer balance-sheet constraints**: intermediaries reduce market-making capacity.
- **One-sided order flow**: many sellers (or buyers) at the same time, often due to crowded positioning.
- **Higher volatility**: market makers widen spreads to protect against adverse selection.
- **Uncertainty about valuation**: investors demand a larger liquidity premium to hold assets.
- **Market structure frictions**: outages, limit moves, or broken hedging relationships.

A key exam idea is that market liquidity is state-dependent: it is often abundant in calm conditions and scarce in stress, when it is most needed.

### Worked Example 1.1

A trader must sell an equity position quickly. The stock’s mid-price is \$50. The bid-ask spread is 0.40% of price. The position is 100,000 shares. Estimate the execution cost due only to crossing the spread (ignore market impact).

> **Answer:**  
> The total notional at the mid-price is:  
> $$\text{Notional} = 50 \times 100{,}000 = \$5{,}000{,}000$$  
> The spread is 0.40%, so the **half-spread** cost (typical cost for a one-way liquidation) is 0.20%.  
> $$\text{Spread cost} = 0.002 \times 5{,}000{,}000 = \$10{,}000$$  
> Estimated execution cost from crossing the spread is **\$10,000**.

This example shows why market liquidity risk is not just “can you trade?” but “at what cost, and with what price uncertainty?”

## **Funding Liquidity Risk**

Funding liquidity risk is the risk that a firm cannot meet cash outflows when due, or cannot raise funding on reasonable terms. It includes the inability to roll short-term liabilities, obtain secured or unsecured borrowing, or post collateral required by counterparties and clearing houses.

> **Key Term: Funding liquidity risk**  
> The risk that an institution cannot meet expected and unexpected cash and collateral outflows without materially affecting its operations or financial condition.

### Where funding pressure comes from

Funding stress often arrives through one (or more) of the following channels:

1. **Liability withdrawals or non-rollover**
   - deposit outflows, commercial paper that cannot be reissued, repo that is not renewed.
2. **Collateral calls**
   - variation margin (mark-to-market losses), initial margin increases, or additional collateral demanded under CSA terms.
3. **Higher secured funding haircuts**
   - lenders reduce the amount they will lend against collateral, forcing borrowers to post more equity/cash.
4. **Downgrades and covenant triggers**
   - higher funding spreads, termination events, or additional collateral requirements.

> **Key Term: Haircut**  
> In secured borrowing (e.g., repo), the percentage discount applied to collateral value. If collateral value is $V$ and haircut is $h$, the maximum borrowing is $(1-h)V$.

### Funding liquidity and “gearing” effects

Positions financed with borrowed funds (high **gearing**) are more sensitive to adverse price moves because small mark-to-market losses can create large collateral needs relative to equity. A simple balance-sheet relation is:

$$\text{Gearing} = \frac{\text{Assets}}{\text{Equity}} = 1 + \frac{\text{Debt}}{\text{Equity}}$$

Higher gearing means less equity buffer to absorb price moves before forced sales or funding actions become necessary.

### Worked Example 2.1

A \$100 million bond position is financed in the repo market. The initial haircut is 5%. The haircut rises to 12% while the bond price is unchanged. How much additional cash collateral must be posted?

> **Answer:**  
> Equity (cash) required under a haircut $h$ is:  
> $$\text{Equity required} = hV$$  
> Initial equity required:  
> $$0.05 \times 100{,}000{,}000 = \$5{,}000{,}000$$  
> New equity required:  
> $$0.12 \times 100{,}000{,}000 = \$12{,}000{,}000$$  
> Additional collateral needed:  
> $$12{,}000{,}000 - 5{,}000{,}000 = \$7{,}000{,}000$$  
> The additional cash collateral required is **\$7 million**.

For risk managers, this is the core mechanism: even if the asset price does not move, tighter funding terms can force cash outflows.

## **How Market and Funding Liquidity Interact**

Market and funding liquidity are distinct, but in stress they often move together and create feedback loops.

### The liquidity spiral mechanism

A typical “spiral” works as follows:

1. **Asset prices fall or volatility rises**
2. **Margins increase and haircuts rise** (funding liquidity worsens)
3. **Firms must raise cash** by selling assets or reducing positions
4. **Forced selling pushes prices down further** (market liquidity worsens via impact and wider spreads)
5. The cycle repeats, often spreading across assets as correlations rise during stress

> **Key Term: Liquidity spiral**  
> A self-reinforcing feedback loop in which tighter funding (higher margins/haircuts) triggers asset sales that reduce market liquidity and prices, which then further tightens funding conditions.

Two exam-relevant implications follow:

- Liquidity risk is often **system-wide** in stress: many participants try to sell similar assets simultaneously.
- Risk models calibrated to “normal” conditions can fail because they do not capture changing liquidity conditions and rising cross-asset correlations.

### Liquidity and credit spreads

For bonds and loans, observed spreads include more than expected default losses and risk premia. A further component is often a **liquidity premium**: investors demand compensation for holding assets that are costly to sell quickly. This is one reason spreads can widen sharply in stress even without an immediate change in expected default frequency.

## **Including Liquidity in VaR and ES**

VaR and ES are typically calculated from price changes over a chosen holding period. Implicitly, the holding period assumes the position can be exited or hedged within that horizon. Illiquidity challenges that assumption in two ways:

1. **Longer liquidation horizon**: the position may require days or weeks to exit without excessive impact.
2. **Extra loss component**: liquidation involves spread costs and market impact beyond “mid-price returns.”

### Liquidation horizon adjustments

If returns were independent and identically distributed, a simple scaling rule is:

$$\text{VaR}(T) \approx \text{VaR}(1)\sqrt{T}$$

But liquidity events are precisely the situations where IID assumptions can be least reliable: volatility clusters, gaps occur, and markets can become one-sided. For exam purposes, remember the direction: if liquidation horizon increases materially, measured risk should generally increase, and naive square-root-of-time scaling can understate risk in stress.

### Liquidity-adjusted VaR concept

A common adjustment is to add an estimate of liquidation cost to the usual VaR. One simple form is:

$$\text{LVaR} \approx \text{VaR}_{\text{mid}} + \text{Half-spread cost} + \text{Market impact cost}$$

Where:

- $\text{VaR}_{\text{mid}}$ is computed on mid-price returns (as in many standard market risk systems),
- half-spread approximates the cost to exit one side of the market,
- market impact reflects price pressure from trade size relative to market depth.

### Worked Example 4.1

A desk holds the equity position from Worked Example 1.1: 100,000 shares at a \$50 mid-price. One-day volatility is 2%. Assume mean return is 0. Use a 99% normal VaR with $z = 2.33$. The bid-ask spread is 0.40% (as before). In addition, estimate market impact as \$40,000 for this liquidation. Compute a simple liquidity-adjusted VaR.

> **Answer:**  
> Step 1: Compute mid-price VaR on notional.  
> $$\text{Notional} = 50 \times 100{,}000 = \$5{,}000{,}000$$  
> $$\text{VaR}_{\text{mid}} = z \sigma \times \text{Notional} = 2.33 \times 0.02 \times 5{,}000{,}000$$  
> $$\text{VaR}_{\text{mid}} = 2.33 \times 100{,}000 = \$233{,}000$$
>
> Step 2: Add half-spread liquidation cost (from Worked Example 1.1).  
> $$\text{Half-spread cost} = \$10{,}000$$
>
> Step 3: Add market impact estimate.  
> $$\text{Impact cost} = \$40{,}000$$
>
> Step 4: Sum components.  
> $$\text{LVaR} \approx 233{,}000 + 10{,}000 + 40{,}000 = \$283{,}000$$  
> The liquidity-adjusted VaR is **approximately \$283,000**.

This type of adjustment is simple, but it highlights the main FRM point: risk measures based only on mid-price moves can miss liquidation costs that become material in stress.

### **Exam Warning**

> Do not equate “liquidity risk” with only one concept (e.g., bid-ask spread). Market liquidity includes depth and impact, while funding liquidity includes margins, haircuts, rollover risk, and cash-flow timing. Also, a short VaR holding period implicitly assumes the position can be exited or hedged within that horizon.

## **Liquidity Stress Testing and Governance**

Because liquidity is state-dependent and can change quickly, institutions rely heavily on stress testing and scenario analysis rather than a single closed-form metric.

Stress tests are forward-looking and typically do not assign probabilities to loss outcomes. They are designed for adverse conditions that are unlikely but possible, and they are particularly relevant to liquidity adequacy and capital funding plans.

### Governance roles in liquidity-related stress testing

Sound stress testing requires clear responsibilities across the organization:

- **Board of directors**
  - Sets risk appetite and risk culture, and provides oversight for key strategies.
  - Reviews stress-test results critically, challenges assumptions, and avoids relying on a single exercise.
  - Uses results as an early warning sign, including for actions such as increasing liquidity, adjusting risks, or changing activities.
- **Senior management**
  - Implements board-authorized stress testing through policies and procedures.
  - Ensures assumptions are transparent and applied consistently.
  - Uses a _series_ of stress tests (not one) to support decisions on business strategy and risk taking.
- **Internal audit and independent review**
  - Provides objective review of processes, documentation, and remediation of identified issues.
  - Validation should be unbiased, cover judgmental elements, and monitor results routinely.

A recurring stress testing lesson is that correlations often increase during stress. Reviews should account for this, and using multiple models together can provide more informative loss estimates than a single model in isolation.

### Stressed risk metrics and liquidity

Stressed VaR or stressed ES can be useful when current conditions appear calm but the institution wants risk metrics that reflect severe historical environments. A central advantage is that stressed measures are typically more conservative, supporting capital and liquidity planning.

However, stressed inputs may be less aligned with current market conditions. For liquidity risk, this means stress design should be explicit about mechanisms such as spread widening, depth reduction, and haircut increases, rather than assuming historical prices alone capture shifts in liquidity conditions.

## **Risk Management Actions for Liquidity Risk**

Risk managers typically address liquidity risk through a mix of measurement, limits, buffers, and operational readiness:

1. **Liquidity buffers**
   - hold high-quality liquid assets that can be monetized even in stress (with appropriate haircuts).
2. **Funding diversification**
   - avoid concentrated reliance on one short-term funding channel or counterparty.
3. **Collateral and margin management**
   - monitor potential variation margin and initial margin increases under stress; pre-position collateral.
4. **Position sizing linked to market capacity**
   - set limits relative to average daily volume and expected market impact.
5. **Contingency funding plan**
   - pre-agreed actions for stress: secured funding options, asset sales sequencing, and escalation governance.
6. **Integrated stress tests**
   - combine market shocks with funding shocks (spreads widen, haircuts rise, and correlations increase together).

These tools are most effective when market and funding liquidity are managed jointly, because stress typically hits both at once.

## **Summary**

Market liquidity risk is about trading: the cost and feasibility of executing transactions without large price concessions. Funding liquidity risk is about cash and collateral: the ability to meet obligations and roll financing without disruptive actions. Both can be stable in normal conditions and then deteriorate quickly under stress.

For FRM Part 1, the key is not just definitions but the interaction. Collateral calls, margin increases, and higher haircuts can force asset sales. Those sales can depress prices and widen spreads, making liquidation even more expensive and reinforcing funding stress. This feedback loop is why liquidity is central to stress testing, governance, and conservative risk measurement choices such as stressed VaR/ES.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Market liquidity risk concerns execution costs, market impact, and liquidation uncertainty
- Funding liquidity risk concerns meeting cash and collateral outflows and rolling financing
- Haircuts and margins transmit volatility and price declines into funding stress
- Market and funding liquidity can interact through self-reinforcing liquidity spirals
- VaR/ES should reflect liquidation horizons and potential execution costs in illiquid markets
- Stress testing is a primary tool for liquidity adequacy assessment and requires strong governance and independent review

## **Key Terms and Concepts**

- Liquidity risk
- Market liquidity risk
- Funding liquidity risk
- Bid-ask spread
- Market impact
- Market depth
- Haircut
- Initial margin
- Variation margin
- Margin call
- Gearing ratio
- Liquidity spiral
- Liquidity premium (in credit spreads)
- Liquidation horizon
- Liquidity-adjusted VaR (LVaR)
- Stress testing governance
- Stressed VaR and stressed ES
- Contingency funding plan


Liquidity risk and balance-sheet risk - Market vs funding liquidity risk