CFA Level I · CFA Level I Exam · Alternative Investment Features, Methods, and Structures
An investor is reviewing a private equity fund and notes that reported returns are based on infrequent appraisals rather than market prices. Compared with the true volatility of the underlying assets, the reported volatility is most likely:
Reported volatility is most likely understated. Appraisal-based valuations are updated infrequently and lag market prices, which smooths the return series. This lowers measured standard deviation and correlations with traditional assets, making the alternative investment look less risky than it truly is.
- Aunderstated, because appraisal smoothing dampens fluctuationsCorrect
- Baccurate, because appraisals are performed by independent experts
- Coverstated, because appraisals add valuation noise to every period
Explanation
Appraisal-based valuations lag market movements and smooth the return series. This lowers measured standard deviation and correlation with public markets, so risk is understated. Independent appraisers do not remove the smoothing effect, and the noise does not raise volatility overall.
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