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Answer: 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.
## Explanation Option C is the correct answer because it accurately describes key due diligence criteria for evaluating a hedge fund's risk management process: - **Leverage Risk Assessment**: For leveraged funds, understanding how they estimate and manage leverage-related risks is crucial - **Funding Liquidity Risk**: During market stress periods, funding liquidity risk becomes particularly important for leveraged funds - **Comprehensive Risk Evaluation**: This approach considers multiple dimensions of risk management **Why other options are incorrect:** - **Option A**: While tail risk is important, requiring extreme value theory at 99.99% level is overly prescriptive and not practical for all funds - **Option B**: While independent risk oversight is valuable, it's not an absolute requirement that service providers must play "important roles" in risk decisions - **Option D**: A blanket rule against funds with more than 10% model-based valuations is too rigid and doesn't consider the nature of assets or quality of valuation processes The due diligence process should focus on understanding the fund's overall risk management framework, including how they identify, measure, monitor, and manage various risks, particularly those specific to their strategy and leverage profile.
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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 tail 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.
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