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FRM Part II · FRM Exam Part II · Illiquid Assets

Which practice would best help a risk manager detect return smoothing in a manager's reported monthly track record for an illiquid strategy?

Test for significant positive serial correlation and compare reported volatility with a liquid proxy. Smoothed series typically show persistent autocorrelation and unusually low volatility. A high Sharpe ratio or positive average return cannot reveal smoothing and may be inflated by it.

  1. ATesting for significant positive serial correlation and comparing the standard deviation with that of a liquid proxyCorrect
  2. BChecking only that the Sharpe ratio exceeds that of the benchmark
  3. CConfirming that average returns are positive over the full period
  4. DVerifying that the fund reports annual rather than monthly returns

Explanation

Smoothing leaves signs such as significant positive autocorrelation, unusually low volatility, and low correlation with liquid proxies. A high Sharpe ratio may itself result from smoothing, and positive average returns say nothing about valuation bias.

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