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FRM Part II · FRM Exam Part II · Illiquid Assets

A family office wants to increase its allocation to illiquid assets to capture an illiquidity premium, but it may need cash for unexpected needs. Which approach best aligns the allocation with the investor's liquidity needs?

The best approach is to size the illiquid allocation after stress-testing cash needs in a scenario where liquid assets decline and illiquid funds stop distributing. This ties the allocation to the investor's own ability to meet obligations rather than to peer norms, returns or appraised values.

  1. ASize the illiquid allocation after stress-testing cash needs against a scenario where liquid assets fall and distributions from illiquid funds stopCorrect
  2. BSet the allocation to match the peer median regardless of its own spending needs
  3. CBase the allocation only on the target return of the illiquid funds
  4. DRely on mark-to-model valuations of the illiquid assets as a liquidity source

Explanation

Illiquid allocations should be limited by the investor's ability to meet obligations in stress, when distributions dry up and liquid assets fall. Peer matching and return targets ignore the investor's own liquidity needs, and appraised values cannot be turned into cash on demand.

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