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FRM Part II · FRM Exam Part II · Illiquid Assets

A hedge fund reports monthly returns with first-order autocorrelation of 0.40 because many of its positions are marked using stale dealer quotes. An analyst computes annualized volatility by multiplying monthly volatility by the square root of 12. Which conclusion is most appropriate?

Annualized volatility is understated and the Sharpe ratio overstated. Positive autocorrelation from stale pricing makes multi-period variance larger than the square-root-of-time rule implies, and smoothing also depresses measured monthly volatility, so the fund looks less risky than it truly is.

  1. AThe annualized volatility is overstated because positive autocorrelation reduces variance
  2. BThe annualized volatility is understated, and the Sharpe ratio is likely overstatedCorrect
  3. CThe estimate is unbiased because the square-root-of-time rule holds for autocorrelated returns
  4. DOnly the mean return is affected, not volatility

Explanation

With positive autocorrelation, multi-period variance exceeds the sum of single-period variances, so the square-root-of-time rule understates annual volatility. Monthly volatility is also understated by smoothing. Lower volatility inflates the Sharpe ratio.

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