FRM Part II · FRM Exam Part II · Illiquid Assets
A fund has a 60% allocation to listed equities and 40% to illiquid assets. During a market stress, it faces capital calls and redemptions that must be met from the liquid sleeve, which falls in value while the illiquid sleeve is not marked down. What is the key portfolio risk this situation illustrates?
This illustrates the denominator effect: liquid assets fall while illiquid valuations lag, so illiquid weight appears too high and cash needs must be met by selling liquid assets at depressed prices. It is a liquidity-driven portfolio risk, not a diversification benefit.
- AThe denominator effect, where the illiquid share appears to rise and forced sales of liquid assets can occur at depressed pricesCorrect
- BThe diversification benefit, where illiquid assets reduce the need for any liquidity buffer
- CReinvestment risk, where coupon proceeds are reinvested at lower rates
- DBasis risk between futures and the cash market
Explanation
When liquid assets fall and illiquid valuations lag, the illiquid share exceeds target and cash needs fall on the liquid sleeve. This forces selling at low prices and is the denominator effect. The other options describe unrelated risks.
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