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FRM Part II · FRM Exam Part II · Illiquid Assets

An endowment holds 70% in liquid public equities and 30% in private equity. Reported private equity returns are based on smoothed appraisals. The risk manager computes portfolio volatility from reported returns and compares it with a figure after unsmoothing. Which outcome is most likely?

Reported volatility understates true risk because appraisal smoothing creates positive autocorrelation and dampens measured variance and correlation with public markets. Unsmoothing the returns raises estimated volatility and correlation, giving a more realistic picture of the portfolio's risk.

  1. AReported-return volatility overstates true portfolio risk because appraisals add noise
  2. BReported-return volatility understates true portfolio risk, and unsmoothing would raise estimated volatility and correlation with public equitiesCorrect
  3. CUnsmoothing lowers estimated volatility because it removes autocorrelation
  4. DSmoothing affects the mean return but has no effect on volatility or correlations

Explanation

Appraisal smoothing induces positive autocorrelation and dampens measured variance and correlation with liquid markets. Unsmoothing removes this effect, so volatility and market correlation estimates rise. The option claiming overstatement reverses the direction of the bias.

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