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FRM Part II · FRM Exam Part II · The Rise and Risks of Private Credit

A risk manager notes that a private credit fund reports smooth quarterly returns with low volatility versus a public high-yield index. Which is the most appropriate interpretation for risk measurement?

Reported volatility of private credit is likely understated because illiquid loans are valued infrequently using models, which smooths returns. The low figure therefore should not be taken as evidence of lower economic or credit risk than a public high-yield index.

  1. AReported volatility may understate true risk because infrequent, model-based valuations smooth returns, so it should not be read as proof of lower economic riskCorrect
  2. BThe low volatility proves the fund has lower credit risk than the index
  3. CSmoothing causes reported volatility to be overstated, so risk is lower than it appears
  4. DValuations are fully market based, so the volatility comparison is reliable

Explanation

Illiquid loans are valued infrequently using models, which smooths returns and biases volatility and correlation downward. This does not demonstrate lower credit risk. Overstatement is the opposite of the effect, and valuations are not market based.

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