FRM Part II · FRM Exam Part II · Illiquid Assets

A pension fund's investment committee notes that its private real estate and infrastructure holdings cannot be sold quickly at a price close to their reported values. Which statement best describes the compensation investors typically expect for bearing this characteristic?

Investors expect a liquidity premium: higher expected returns for holding assets that are slow or costly to trade. This compensates for the inability to exit at fair value quickly, especially in stress. Smoothed, low reported volatility does not reduce this required compensation, and liquidity risk is not simply diversifiable.

AA liquidity premium, meaning higher expected returns for assets that are costly or slow to tradeCorrect
BA lower expected return, because illiquid assets are less volatile on a reported basis
CNo additional return, because liquidity risk is fully diversifiable
DA credit spread, because illiquidity is equivalent to default risk

Explanation

Investors who accept the inability to trade quickly or cheaply demand a higher expected return, the liquidity premium. Reported volatility of illiquid assets is understated by smoothing, so it is not a reason to expect lower returns. Liquidity risk is largely systematic, rising in market stress, so it is not simply diversifiable.

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