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Explanation:
B is correct. Risk measurement and reporting and the decision to take action is evolving toward a more independent model that segregates risk taking and investing from risk measurement and management. Many funds have dedicated risk managers who report to the CIO or the CEO independently from the portfolio managers and traders. In addition, many firms also employ independent risk service providers to report risk to investors completely independently from the firm.
A is incorrect. It is important to understand the inputs and assumptions used in the firm's risk models, and this is most effective when the same system that is used to monitor risk is also used in risk reporting. Too often, traders use a different system with different inputs and outputs to monitor their risk than the firm is using to report risk to investors. This can result in significant miscommunication and lead to problems when things go wrong.
C is incorrect. Hedge funds do not necessarily have the same levels of liquidity and leverage. Some strategies such as global macro have fairly uniform leverage terms and liquidity based on the products they trade. However, other strategies such as fixed income and convertibles use varying degrees of leverage and have very different liquidity profiles. Therefore, an investor should not expect these levels to be the same across funds. However, investors still need to evaluate the leverage and liquidity of each portfolio to understand where a particular manager may deviate from peers or exhibit leverage or illiquidity that can cause performance to deviate from the expectation of the strategy.
D is incorrect. Investors should assess whether a hedge fund's terms make sense for the strategy that is being offered. Therefore, they should compare any specific manager or fund to its peers to see if the terms make sense. Law firms, accountants, and many commercial databases are good sources to collect
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A
Investors should confirm that portfolio managers and traders use an effective system to monitor risk regardless of whether this system is separate from the one used to report risk to investors.
B
Investors should be certain that the fund has adopted an independent risk management function regardless of whether this function is carried out by dedicated risk managers at the fund or by a risk service provider.
C
Investors should make sure that all portfolio managers use equivalent levels of liquidity and leverage, which are consistent with the terms set by the fund's risk plan, and maintain these levels over time.
D
Investors should acknowledge that the terms of the fund are unique to the hedge fund being considered for investment, and therefore, the fund should be the only source of information regarding the terms applied.