FRM Part II · FRM Exam Part II · Illiquid Assets
A pension fund holds a private equity portfolio whose reported NAVs are based on appraisals updated quarterly. An analyst computes volatility and correlation with public equities from these reported returns. Which statement best describes the likely bias in these statistics?
Volatility and correlation with public equities are both understated. Appraisal-based valuations smooth returns and lag market moves, which dampens reported swings and weakens contemporaneous correlation, so the asset appears less risky and more diversifying than its true economic exposure.
- AVolatility is overstated and correlation with public equities is overstated
- BVolatility is understated and correlation with public equities is understatedCorrect
- CVolatility is understated and correlation with public equities is overstated
- DVolatility is overstated and correlation with public equities is understated
Explanation
Appraisal-based valuations are smoothed and lag market movements. Smoothing dampens reported return swings, so volatility is understated, and the lag weakens contemporaneous correlation with public markets, so correlation is understated. Both together make the asset look more diversifying than it is. The option pairing understated volatility with overstated correlation gets the lag effect wrong.
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