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FRM Part II · FRM Exam Part II · Private Markets Investing

An investor reviews a private equity fund's quarterly reports. Reported quarterly returns have a standard deviation of 3.0% and a first-order autocorrelation of 0.50, indicating smoothing. Which is the most accurate implication for risk estimates based on these returns?

Positive autocorrelation signals appraisal smoothing, which understates measured volatility and also biases correlations and betas downward. The investor should unsmooth the return series before computing risk measures such as VaR or volatility.

  1. AMeasured volatility is likely understated, so the investor should unsmooth the returns before estimating riskCorrect
  2. BMeasured volatility is overstated because positive autocorrelation adds noise
  3. CAutocorrelation has no effect on volatility or correlations with public markets
  4. DMeasured correlation with public equities is likely overstated

Explanation

Positive autocorrelation from appraisal-based smoothing dampens reported variance and lowers measured correlation with public markets and beta. Unsmoothing, for example with the Geltner approach, r* = (r - ρ·r_lag)/(1-ρ), raises estimated volatility. Hence understated volatility is the implication.

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