FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies
A risk manager observes that a hedge fund's reported monthly returns show a first-order autocorrelation of +0.45, and the fund holds mostly illiquid, hard-to-price securities. What is the most likely effect on the fund's reported risk statistics?
Positive autocorrelation from smoothed or stale pricing of illiquid assets understates reported volatility. Because the Sharpe ratio divides excess return by volatility, it is overstated. The distortion also understates betas and correlations with markets, making the fund look safer than it is.
- AReported volatility and Sharpe ratio are understated and overstated respectivelyCorrect
- BReported volatility and Sharpe ratio are both overstated
- CReported volatility is overstated and the Sharpe ratio understated
- DReported statistics are unaffected because autocorrelation does not alter the mean
Explanation
Positive autocorrelation from stale or smoothed pricing dampens reported volatility. Since the Sharpe ratio divides excess return by volatility, understated volatility inflates it. Correlations to markets and betas are also understated.
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