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

A pension fund allocates to a private credit manager that reports very smooth monthly returns with low volatility. A risk analyst suspects that valuation practices understate risk. Which adjustment is most appropriate when estimating the portfolio's true risk?

The analyst should unsmooth the reported returns. Stale or model-based valuations create artificial smoothness, understating volatility and correlation with public markets. Correcting for this usually raises estimated risk, giving a more realistic view than the reported figures, which are unreliable even when audited.

  1. AUnsmooth the returns to correct for stale or model-based valuations, which typically increases estimated volatility and correlation to public marketsCorrect
  2. BUse the reported volatility unchanged because it is audited
  3. CReduce the estimated volatility further because illiquid assets are less sensitive to market moves
  4. DReplace volatility with the coupon rate as the risk measure

Explanation

Infrequent, model-based marks create serial correlation and understate volatility and market correlation. Unsmoothing corrects this and generally raises measured risk. Audited marks still rely on the same valuation method, and lower volatility from illiquidity is only apparent.

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