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FRM Part II · FRM Exam Part II · Illiquid Assets

A pension fund holds a private equity portfolio whose reported NAV is based on quarterly appraisals by the general partners. The risk manager notes that the reported return volatility is much lower than that of listed small-cap equities with similar business exposure. Which statement best explains this observation?

Reported private equity volatility is lower because appraisal-based valuations are smoothed and stale, reacting slowly to market moves. This understates true volatility and correlation with public markets, so risk measures based on reported returns are biased downward.

  1. AAppraisal-based valuations are smoothed, which understates volatility and market correlationCorrect
  2. BPrivate equity firms use higher leverage, which mechanically reduces return volatility
  3. CPrivate equity cash flows are fully hedged through J-curve effects
  4. DQuarterly reporting increases measured volatility relative to daily pricing

Explanation

Appraisal-based NAVs adjust slowly to market information, creating stale or smoothed prices. This produces artificially low volatility, low correlation with public markets and positive serial correlation. Higher leverage would raise, not lower, volatility.

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