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FRM Part II · FRM Exam Part II · Illiquid Assets

A endowment's investment committee compares a listed infrastructure fund with an unlisted one with similar underlying assets. Which statement best describes the appropriate treatment of the illiquidity premium in the unlisted fund?

The illiquidity premium is compensation for accepting lock-ups and the inability to trade readily, so it should be weighed against the endowment's own liquidity needs and horizon. It is not risk-free, and low reported volatility is merely a smoothing artifact.

  1. AThe extra expected return is compensation for bearing lock-up and inability to trade, and should be weighed against the endowment's own liquidity needsCorrect
  2. BThe premium is a risk-free return because lock-ups remove market risk
  3. CThe premium disappears once reported volatility is measured, since reported volatility is low
  4. DThe premium should be ignored because illiquid assets have identical expected returns to liquid ones

Explanation

Illiquidity premium compensates investors for being unable to sell quickly or at low cost; its value depends on the investor's capacity to hold. Low reported volatility is a smoothing artifact, not true risk removal.

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