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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A risk analyst studies a hedge fund that holds illiquid, hard-to-price convertible bonds and marks them using stale dealer quotes. The fund's reported monthly returns show a strongly positive first-order autocorrelation. Which conclusion is most appropriate?

Positive autocorrelation from stale or smoothed pricing makes reported volatility look lower than true economic volatility. With the denominator understated, the Sharpe ratio is overstated. Measured beta and correlations are also typically biased downward, so the fund looks safer than it is.

  1. AReported volatility is probably understated and the Sharpe ratio overstatedCorrect
  2. BReported volatility is probably overstated and the Sharpe ratio understated
  3. CReported beta to market factors is probably overstated
  4. DThe fund's skewness must be positive

Explanation

Stale pricing smooths returns, creating positive autocorrelation. Smoothed returns have lower measured standard deviation and understate correlation and beta with market factors, so the Sharpe ratio is inflated. Overstated volatility and beta are the opposite effects.

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