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FRM Part I · FRM Exam Part I · Fund Management

A hedge fund holds illiquid positions priced using stale or smoothed marks, so its reported monthly returns show positive autocorrelation. Which effect on reported risk statistics is most likely when an analyst uses these returns directly?

Reported volatility is understated and the Sharpe ratio is overstated. Stale or smoothed pricing of illiquid assets dampens apparent return swings and creates positive autocorrelation, so measured risk is too low while the average return is unchanged, which inflates risk-adjusted performance measures.

  1. AVolatility is overstated and the Sharpe ratio is understated
  2. BVolatility is understated and the Sharpe ratio is overstatedCorrect
  3. CVolatility is understated and the Sharpe ratio is understated
  4. DVolatility is unaffected, but skewness is overstated

Explanation

Smoothed returns dampen the observed swings, reducing measured standard deviation, and positive autocorrelation makes monthly volatility understated when scaled up. With the same mean return and lower measured risk, the Sharpe ratio is overstated.

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