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FRM Part II · FRM Exam Part II · The Rise and Risks of Private Credit

A fund's portfolio of direct loans is valued by the manager using internal models, while a comparable portfolio of public bonds is marked to market daily. During a sharp spread widening, the private loans show a reported 1% decline versus 8% for public bonds. Which is the most appropriate risk management conclusion?

Model-based valuations smooth reported returns, so the small decline likely understates true volatility and correlation with public credit. A risk manager should unsmooth the returns or stress test the loans rather than treat the lower reported volatility as lower economic risk.

  1. AThe private loans have 7% lower economic risk because of the lower reported volatility
  2. BPrivate loans have no spread risk because they are floating rate
  3. CReported return smoothing from model-based valuation likely understates volatility and correlation, so risk should be unsmoothed or stress testedCorrect
  4. DValuation lags increase diversification benefits to the investor

Explanation

Infrequent, model-based marks cause stale or smoothed returns, which understate volatility and correlation with public markets. Risk analysis should adjust for smoothing or use stress tests. Lower reported volatility does not imply lower economic risk, and floating rates do not remove credit spread risk.

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