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FRM Part II · FRM Exam Part II · Illiquid Assets

A risk manager wants to unsmooth reported returns of an illiquid hedge fund strategy that exhibit first-order autocorrelation of 0.3. Which approach is most consistent with standard practice for estimating underlying economic returns?

The standard approach is to unsmooth by removing the autoregressive lag component, using R_true = (R_obs − φ × lagged R_obs)/(1 − φ). This restores the variance hidden by smoothing and gives a better estimate of economic volatility.

  1. AAdjust reported returns by removing the autoregressive component, such as R_true = (R_obs − φR_obs,t-1)/(1 − φ)Correct
  2. BMultiply reported volatility by the square root of the number of months
  3. CReplace reported returns with the risk-free rate
  4. DUse only the best-performing quarters to estimate volatility

Explanation

Unsmoothing removes the lagged component implied by the autocorrelation, restoring a series with higher variance reflecting economic risk. The other options are unrelated to the smoothing structure or are biased.

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