Skip to content

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

A pension fund allocates to a direct-lending vehicle that holds privately negotiated, floating-rate senior loans to middle-market borrowers. The fund's risk officer notes that the vehicle's reported net asset value has been far less volatile than a listed leveraged loan index over the same period. Which is the most appropriate interpretation of this observation?

The low reported volatility most likely reflects smoothing from infrequent, model-based valuations rather than lower true risk. Private loans lack observable prices, so marks lag market conditions and understate volatility and correlation. Seniority or floating coupons do not remove credit risk or explain the artificially stable NAV.

  1. AThe vehicle's loans are inherently less risky because they are senior secured
  2. BReported volatility is likely understated because valuations are model-based and smoothed rather than market-observedCorrect
  3. CThe vehicle must hold more diversified positions than the listed index
  4. DFloating-rate coupons eliminate credit spread risk, so volatility must be lower

Explanation

Private loans are not traded regularly, so marks come from models and appraisals that lag market moves, producing smoothed returns and understated volatility and correlations. Seniority does not explain low measured volatility; it affects loss severity, not the observation frequency. Floating coupons remove most rate risk but not credit spread or default risk.

Did you get it right without looking?

One question tells you little. A timed set on The Rise and Risks of Private Credit shows your real accuracy, how long you take and where you lose marks.

Practise The Rise and Risks of Private CreditFree diagnostic mock

More The Rise and Risks of Private Credit questions