Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which type of risk is NOT explicitly priced into the expected return of a venture capital investment?

1. Market risk

2. Business risk

3. Liquidity risk

4. Idiosyncratic risk

The correct answer is: Market risk

In the context of venture capital investments, market risk is generally considered a systematic risk that affects all investments in the market. Its impact is reflected in expected returns as it represents the broader economic and market factors that can influence portfolio performance, regardless of the specific characteristics of the investment. Venture capitalists often account for market risk in their modeling of expected returns due to its pervasive nature. On the other hand, business risk pertains to the inherent risk associated with the specific business operations and financial performance of the venture in which the capital is invested. This type of risk is explicitly priced into the expected return as it is directly linked to the success or failure of that particular business model. Liquidity risk refers to the potential difficulty in selling an investment without affecting its price. Given that venture capital investments typically lack liquidity, this risk becomes a crucial consideration for investors and tends to be factored into their expected returns. Idiosyncratic risk, which is unique to a particular investment and not correlated with market movements, is also explicitly priced as it reflects individual business risks that can significantly impact potential returns. Thus, among the types of risks listed, market risk falls into a category that is typically already reflected in the expected returns, whereas the other risks are more closely tied to the