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

A fund of funds assigns a probability of fraud or serious operational failure to each candidate. Manager A has an independent administrator, a top-tier auditor, and a prime broker holding assets. Manager B self-administers, uses an unknown auditor, and holds assets at an affiliated broker. Historical data suggest 2% of funds like A and 20% of funds like B suffer serious operational failures. The allocator invests $50 million in each. What is the expected operational-failure-related loss if a failure causes total loss of the invested amount?

The expected loss is $11.0 million. Manager A contributes 2% of $50 million, or $1.0 million, and Manager B contributes 20% of $50 million, or $10.0 million. Summing gives $11.0 million, with nearly all the operational risk coming from the weakly controlled Manager B.

  1. A$7.0 millionCorrect
  2. B$11.0 million
  3. C$14.0 million
  4. D$35.0 million

Explanation

Expected loss A = 0.02 x 50 = $1.0m. Expected loss B = 0.20 x 50 = $10.0m. Total = $11.0m. Check: probability-weighted average on $100m. Hmm: sum is 11.0, so the correct option is $11.0 million.

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