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Extreme Events – Specimen Question A.2.2(a) – Answer/Hints

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Q. You think that the returns shown for Index B may exhibit a material element of smoothing. What sorts of assets might lead to this type of behaviour?

 

Assets that seem to exhibit smoothing in practice are typically ones that take a relatively long time to buy or sell or are otherwise less liquid.

 

A classic example is direct property, i.e. real estate, given the very wide variety of forms that it can take and the often lengthy legal processes and negotiations that are necessary to buy or sell it.

 

However, many other types of asset can also be relatively illiquid, or proved to be less liquid than investors had hoped during the 2007-2009 credit crisis. For example, some times of complicated structured investments proved very illiquid during the credit crisis and could only be traded, if at all, with very wide bid-offer spreads.

 

The equities of smaller companies are often less liquid than their larger brethren.

 


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