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FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds

A due diligence team reviews a hedge fund's risk reporting. Which finding would be the most serious red flag regarding the fund's risk management function?

The most serious red flag is a chief risk officer who reports to the portfolio manager, who can override limits without escalation. This removes independence from the risk function, so limits and monitoring cannot reliably constrain risk-taking by the person whose compensation depends on performance.

  1. AThe risk report uses both VaR and stress tests
  2. BThe chief risk officer reports to the portfolio manager, who can override limits without escalationCorrect
  3. CRisk limits are reviewed annually by the investment committee
  4. DThe fund uses an external vendor system for risk analytics

Explanation

A risk officer who reports to the portfolio manager and whose limits can be overridden has no independence, so limits are ineffective. Using VaR with stress tests, vendor systems and annual limit reviews are normal or good practices.

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