In which scenario is the Sharpe ratio likely to be biased upward?

The Sharpe ratio, which measures the risk-adjusted return of an investment, is likely to be biased upward in scenarios involving illiquid holdings. This bias occurs because illiquid assets often exhibit a return that does not fully reflect their risk.

In practice, illiquid assets tend to have wider bid-ask spreads and may experience price changes that are not fully captured in their reported performance metrics. As a result, the volatility (denominator in the Sharpe ratio calculation) may be understated, leading to an artificially high Sharpe ratio. Investors might perceive these investments as being less risky than they truly are, thus inflating the perceived risk-adjusted return.

In contrast, scenarios such as market volatility or bear market conditions do not inherently lead to an upward bias in the Sharpe ratio. Market volatility typically raises the denominator (risk) in the Sharpe ratio calculation, while bear markets can negatively impact returns, similarly affecting the ratio. Liquid holdings, while often being easier to buy or sell without impacting market price, do not typically exhibit the same distortion in risk perceptions that illiquid holdings do.

Thus, when considering illiquid holdings, the measurement of return may be misleading due to an understatement of risk, resulting in an upward bias in the Sharpe