Concept Checker Answers

1. C Information technology is an important element of structural risk for hedge fund operations but is not a primary risk factor for a hedge fund strategy. Rather, convertible bond strategies, for example, are specifically vulnerable to illiquidity when positions need to be liquidated, credit risk in the form of default, and market risk in the form of widening of risk premiums or increasing market volatility.

2. C Leverage is not a primary risk factor per se, but amplifies expected return and risk. It is not independent of primary risk factors, however, because it can aggravate liquidity risk and market risk. Balance sheet leverage reflects the hedge fund's use of credit, while instrument leverage reflects the risk inherent in the fund's investment instruments. Generally, hedge fund strategies trade off between the two types of leverage.

3. B Maximum disclosure is not appropriate for all hedge fund strategies, particularly information-sensitive strategies that would have difficulty competing with imitators or trading partners if information about their positions and strategy were disseminated to the market place. Extremely frequent and timely disclosure has little value for low turnover strategies or strategies with illiquid positions because the costs of disclosure are not offset by the benefits of frequent and timely transparency.

4. A Much of the analysis regarding asset allocation is derived from quantitatively oriented optimization techniques. Hedge fund returns are not typically normally distributed, however. Asset allocation should therefore focus on risk measures relating to the loss portion of the distribution of returns. Due diligence, rather that asset allocation, focuses on analysis a hedge funds structural or operating risks.

5. B The purpose of risk monitoring and management is not to replicate security selection that should take place at the investment level. Rather, it focuses on identifying situations that might lead to style drift among managers. If returns fall outside a specific confidence interval, for example, the risk manager should implement predefined responses such as data gathering and possible redemption. As quantitative risk management techniques, VAR is ideal for directional strategies and stress testing is important for strategies prone to liquidity risk.

The following is a review of the Risk Management and Investment Management principles designed to address the AIM statements set forth by GARPĀ®. This topic is also covered in:

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