Module: | MODULE B: RISK MANAGEMENT
Q368: Scenario: XYZ Bank holds a massive, highly concentrated position in lower-rated, illiquid corporate bonds within its trading book. The Risk Management Committee (RMC) is reviewing the Value at Risk (VaR) model assumptions.
When calculating the VaR for this specific portfolio under normal market conditions, how must the risk management team adjust the assumed liquidation timeframe (defeasance period) compared to a highly liquid government security portfolio?
✅ Correct Answer: A
The correct answer is A. The "defeasance period" (or holding period/liquidation horizon) is the estimated time required to close out or hedge a position without materially affecting the market price.
For highly liquid assets like G-Secs, this period might be just 1 to 3 days.
However, for a massive, concentrated position in illiquid, lower-rated corporate bonds, selling the entire block quickly would trigger a "fire sale," crashing the market price.
To capture this Market Liquidity Risk accurately, risk managers must significantly increase the assumed defeasance period in their VaR calculations (e.g., to 30 days or more). Option B is disastrously incorrect; rushing a sale destroys value.
Option C is incorrect because modern risk frameworks demand liquidity-adjusted horizons tailored to the specific asset class.
Option D is irrelevant.
For highly liquid assets like G-Secs, this period might be just 1 to 3 days.
However, for a massive, concentrated position in illiquid, lower-rated corporate bonds, selling the entire block quickly would trigger a "fire sale," crashing the market price.
To capture this Market Liquidity Risk accurately, risk managers must significantly increase the assumed defeasance period in their VaR calculations (e.g., to 30 days or more). Option B is disastrously incorrect; rushing a sale destroys value.
Option C is incorrect because modern risk frameworks demand liquidity-adjusted horizons tailored to the specific asset class.
Option D is irrelevant.