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FRM Part II · FRM Exam Part II · Illiquid Assets

A risk manager wants to estimate the true risk of a portfolio of private equity funds using reported NAV returns that are smoothed. Which approach best addresses the bias?

Unsmooth the reported return series by removing the estimated autocorrelation before computing volatility and VaR. Stale, appraisal-based NAVs mute variance, so the adjustment restores a more realistic risk estimate. Simple annualization or IRR averaging leaves the bias in place or uses an unsuitable measure.

  1. AUnsmooth the reported return series, for example by removing the estimated autocorrelation, before computing volatility and VaRCorrect
  2. BScale reported monthly volatility by the square root of 12 to annualize and treat the result as unbiased
  3. CUse only the most recent quarter of returns, because older NAVs are stale
  4. DReplace the returns with the commitment-weighted average of fund IRRs

Explanation

Unsmoothing reverses the autocorrelation induced by stale valuations, such as R_true = (R_obs - a R_obs(t-1))/(1 - a), restoring variance. Square-root-of-time scaling on smoothed data keeps the bias and, with positive autocorrelation, understates annual risk. A short window loses information, and IRRs are not periodic returns suitable for volatility.

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