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Explain the recommended ways for an investment fund to control its exposure to liquidity risk.

FRM® Part II · Risk Management and Investment Management · Liquidity Risk Management · FRM2.IM.16.a

The idea

A fund controls liquidity risk first through design: the redemption terms it offers, meaning dealing frequency, notice period and minimum holding, should match the time its assets need to be sold without material price impact. Recommended practice adds a liquidity risk framework with clear governance. It sets limits on the share of hard-to-sell assets and on investor concentration, and it runs regular stress tests of both asset liquidity and redemption behaviour. Anti-dilution tools complete the set. Swing pricing moves the dealing price by a swing factor when net flows pass a threshold, so the investors who trade bear the transaction costs instead of those who stay. Without anti-dilution tools, the harm to the remaining holders is measured by Dilution = selling cost ÷ NAV left after redemptions. The usual mistake is judging liquidity in calm markets or by average spread alone. For the exam, tie each tool to its problem: mismatch, first-mover advantage or dilution.

Formulas

Swung dealing price

Swung price = NAV × (1 ± swing factor)

NAV
the unswung NAV per unit
swing factor
the percentage adjustment for dealing costs

Applies only when net flows pass the swing threshold: down for net redemptions, up for net subscriptions, so dealers bear the costs they cause.

Dilution of remaining investors without swing pricing

Dilution = selling cost ÷ NAV remaining

selling cost
the cost of selling assets to pay the redemptions
NAV remaining
the fund's NAV left after the redemptions

Without anti-dilution tools the whole selling cost falls on the investors who stay, which gives redeemers a first-mover advantage.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which design feature is most consistent with recommended practice for controlling an investment fund's liquidity risk?

  1. Matching dealing frequency and notice periods to how quickly assets can be sold at little cost - correct
  2. Offering daily dealing on every fund regardless of asset type, since evaluated prices show what the assets are worthWhy not: Treats evaluated prices as executable prices and ignores the mismatch between redemption terms and asset liquidity.
  3. Concentrating in the least liquid assets available so the fund captures the largest illiquidity premiumWhy not: Maximises the liquidity mismatch that the recommended practice is meant to remove.
  4. Judging liquidity only from average bid-ask spreads in normal markets and setting no limits on illiquid holdingsWhy not: Calm-market spreads ignore stress and trade size, and having no limits is not a control at all.

Recommended practice is to match the fund's redemption terms (dealing frequency, notice, gates in the documents) to the liquidity of its assets, supported by limits and stress tests. The other designs widen the mismatch or rely on calm-market spreads.

A harder one

A daily-dealing bond fund holds 45% of NAV in bonds that its liquidity analysis says need 10 to 20 days to sell without large price impact. Its five largest investors own 35% of the units and can redeem on same-day notice. Which recommended response addresses the structural problem most directly?

  1. Raise the swing factor so that redeeming investors pay more of the cost of each saleWhy not: Swing pricing compensates remaining investors for cost but gives the fund no extra time to sell and does not fix the mismatch.
  2. Move to amortised-cost valuation so that the NAV does not fall when bond prices declineWhy not: Hides losses, rewards the first to redeem and does nothing to the time needed to sell the assets.
  3. Lengthen notice for large redemptions and cap hard-to-sell assets so terms match asset liquidity - correct
  4. Place the illiquid bonds in a sister fund that keeps the same daily dealing termsWhy not: Relabels the assets without changing the mismatch between dealing terms and liquidity.

The problem is a mismatch plus investor concentration. Longer notice for large redemptions and a cap on illiquid assets attack both. Swing pricing, valuation changes and relabelling leave the fund unable to sell in time.

The hardest tier

A fund with NAV of USD 1,000 million has no swing pricing. Investors redeem 20% of NAV (USD 200 million) at NAV, and the fund sells assets to pay them at a cost of 1.5% of the amount sold. By how much does NAV per unit fall for the investors who remain? Closest to:

  1. 1.50%Why not: Applies the 1.5% selling cost rate to the whole remaining holding rather than to the USD 200 million that was sold.
  2. 0.38% - correct
  3. 0.30%Why not: Divides the USD 3.0 million cost by the original NAV of USD 1,000 million instead of the USD 800 million that remains.
  4. 0.19%Why not: Assumes the redeeming investors share half the cost, but they are paid in full at NAV so the remaining investors bear all of it.

Cost = 1.5% x 200 = USD 3.0 million, borne entirely by the remaining units. NAV left = 800 - 3.0 = 797, so the fall is 3.0 / 800 = 0.375%, about 0.38%. This is the dilution that swing pricing is meant to prevent.

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