Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

How do smoothed or stale asset values affect historic return volatility estimation?

1. They enhance the estimation of return volatility

2. They have no effect on return volatility estimates

3. They understate risk, thus lowering the return volatility

4. They overstate risk, thus increasing the return volatility

The correct answer is: They understate risk, thus lowering the return volatility

Smoothed or stale asset values can lead to an understatement of risk when estimating historical return volatility. When asset prices are smoothed, it results in less frequent updates to their valuations, which means that significant price movements might not be captured accurately in the return calculations. As a result, periods of higher volatility may appear less volatile because the prices do not reflect the true market conditions. Consequently, the historical return volatility derived from such smoothed data would be lower than if the asset values were updated in a timely manner to reflect the latest market movements, thus giving a false sense of security about the risk involved in holding such assets. This understated perception of return volatility can mislead investors regarding the actual risk profile of an investment, making it especially critical for those managing alternative investments to be aware of how the smoothing of asset values can impact their assessments of volatility and risk.