FRM Part II · FRM Exam Part II · Illiquid Assets
A pension fund's investment committee notes that its private real estate holdings are valued quarterly by appraisal and trade only infrequently. Which statement best describes the main reason investors may demand a higher expected return on such illiquid assets than on comparable liquid assets?
Investors demand a higher expected return on illiquid assets because they may be unable to sell quickly without accepting a price discount when cash is needed. The illiquidity premium compensates for this exit risk and trading cost, not for lower volatility or guaranteed diversification.
- AIlliquid assets always have lower volatility, so investors are paid for the reduced risk
- BInvestors require compensation for being unable to sell quickly at a fair price when they need cashCorrect
- CIlliquid assets have no correlation with any other asset class, so diversification is guaranteed
- DAppraisal-based valuations remove all uncertainty about the final sale price
Explanation
The illiquidity premium compensates investors for bearing the cost and difficulty of trading, including delayed exit and possible price concessions. Appraisal smoothing understates volatility but is not a source of return compensation. Claims of zero correlation or certainty are not valid.
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