A DUE DILIGENCE SPECIALIST IS EVALUATING THE RISK MANAGEMENT PROCES...

Question

6.

A due diligence specialist is evaluating the risk management process of a hedge fund in which his company is

considering making an investment. Which of the following statements best describes criteria used for such

an evaluation?

a.

Because of the overwhelming importance of tail risk, the company should not invest in the fund unless it

fully accounts for fat tails using extreme value theory at the 99.99% level when estimating VaR.

b.

Today's best practices in risk management require that a fund employ independent risk service providers

and that these service providers play important roles in risk-related decisions.

c.

When considering a leveraged fund, the specialist should assess how the fund estimates risks related to

leverage, including funding liquidity risks during periods of market stress.

d.

It is crucial to assess the fund's valuation policy, and in general if more than 10% of asset prices are based

on model prices or broker quotes, the specialist should recommend against investment in the fund

regardless of other information available about the fund.

Correct Answer: c

Rationale:

Generally speaking, with a leveraged fund, an investor will need to evaluate historical and current

changes in leverage, as well as the level of liquidity of the portfolio, particularly during times of market stress.

Certain strategies may in fact expose an investor to tail risk, so while an investor should inquire whether the

manager believes that tail risk exists, and whether or not it is hedged, it is then up to the investor to decide

whether to accept the risk unhedged or hedge it on their own. Many funds employ independent risk service

providers to report risks to investors, but these firms do not get involved in risk related decision making. And

finally, while it is important to know what percentage of the assets is exchange-traded and marked to market,

what might be acceptable may differ depending on the strategy of the fund.

Section: Risk Management and Investment Management

Learning Objective:

Describe criteria that can be evaluated in assessing a fund’s risk management process.

Reference:

Kevin R. Mirabile, Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation,

Manager Profits, and Fund Performance

(Hoboken, NJ: Wiley Finance, 2013). Chapter 11, “Performing Due Diligence

on Specific Managers and Funds.”

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

2015 Financial Risk Manager (FRM®) Practice Exam