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FRM Part II · FRM Exam Part II · Illiquid Assets

A pension fund holds a private real estate fund whose reported quarterly returns show unusually low volatility and strong positive autocorrelation. The fund's appraisal-based valuations are updated infrequently. Which conclusion is most appropriate for the fund's risk manager?

Reported volatility likely understates true economic volatility. Appraisal-based valuations smooth returns, creating positive autocorrelation and damping measured variance, so Sharpe ratios look inflated and correlations with liquid markets look too low until the series is unsmoothed.

  1. AReported volatility likely understates true economic volatility because of smoothed valuationsCorrect
  2. BReported volatility likely overstates true volatility because appraisals are noisy
  3. CReported Sharpe ratio is unbiased because autocorrelation cancels out over time
  4. DReported correlation with equities likely overstates true correlation

Explanation

Appraisal-based valuations smooth returns, producing positive autocorrelation and understated volatility. Unsmoothing is needed to recover true risk. The overstated-volatility option reverses the effect, and smoothing also tends to understate correlations, not overstate them.

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