CFA Level I · CFA Level I Exam · Hedge Funds
A hedge fund holds thinly traded convertible bonds that are valued using dealers' last available quotes, which are updated infrequently. Compared with the true economic risk, the fund's reported return series will most likely show:
Reported returns will most likely show lower volatility and lower correlation with equity markets. Infrequent, smoothed valuations of illiquid holdings spread price moves over time, which understates true risk and makes the fund look like a better diversifier than it really is.
- Ahigher volatility and higher correlation with equity markets.
- Blower volatility and lower correlation with equity markets.Correct
- Clower volatility and higher correlation with equity markets.
Explanation
Stale or smoothed prices spread price changes across periods, which dampens measured volatility. Lagged prices also reduce measured correlation with markets that move contemporaneously. Both measured risk and diversification benefit are therefore misstated, with risk understated and diversification overstated.
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