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FRM Part II · FRM Exam Part II · Illiquid Assets

An endowment has 40% of its assets in private funds with capital calls and limited distributions. A risk manager wants to assess how the portfolio would fare in a market crisis. Which approach best captures the liquidity risk specific to this allocation?

The best approach is a cash flow stress test that combines higher capital calls, delayed distributions and declines in liquid assets, then checks whether commitments can be met without forced sales. Short-horizon VaR or smoothed appraisal volatility fails to capture this funding liquidity risk.

  1. AStress test cash flows by combining larger capital calls, delayed distributions and falling liquid asset values, and test whether commitments can be met without forced salesCorrect
  2. BRely on the 95% one-day VaR of the liquid portfolio only
  3. CUse appraised net asset values to compute volatility and assume it is unchanged in stress
  4. DAssume distributions rise in a crisis because managers exit holdings quickly

Explanation

Liquidity risk for private fund investors arises from unfunded commitments coinciding with falling liquid assets and slower distributions. A joint cash flow stress test measures the risk of forced sales. One-day VaR and smoothed NAV volatility miss this, and distributions typically slow in crises.

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