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FRM Part II · FRM Exam Part II · Illiquid Assets

A hedge fund's reported monthly returns show first-order autocorrelation of 0.40 because of illiquid holdings priced with stale marks. Under a simple model where observed returns are a weighted average of the true return and the prior observed return, which action is most appropriate when estimating the fund's true risk?

Unsmooth the returns before estimating risk. Positive autocorrelation from stale marks makes naive volatility and square-root-of-time annualization understate true risk and inflate Sharpe ratios, so removing the smoothing recovers a return series closer to the true underlying process.

  1. AUnsmooth the returns to remove the autocorrelation before estimating volatility and Sharpe ratioCorrect
  2. BAnnualize monthly volatility by multiplying by the square root of 12 without adjustment
  3. CUse only the most recent 12 months of returns to avoid stale pricing
  4. DReplace volatility with the average monthly return as the risk measure

Explanation

Positive autocorrelation from stale pricing makes the square-root-of-time scaling understate true volatility and overstate Sharpe ratios. Unsmoothing the series, as in Geltner-type adjustments, recovers returns closer to the true process. Simple annualization ignores the autocorrelation, so it is the key wrong choice.

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