Skip to content

FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

A hedge fund charges a 20% performance fee with no high-water mark, and the manager has discretion over marking illiquid positions. Which conflict of interest is most directly created by this combination?

The key conflict is the incentive to overstate valuations of illiquid holdings. Because performance fees depend on reported returns and the manager controls subjective marks, inflated prices raise fees while investors bear the cost. Independent valuation and oversight are the standard mitigants.

  1. AAn incentive to overstate valuations of illiquid positions to raise fee-bearing performanceCorrect
  2. BAn incentive to reduce leverage to protect investor capital
  3. CAn incentive to hold excess cash to improve liquidity
  4. DAn incentive to disclose more risk information to investors

Explanation

Fees tied to reported performance combined with manager control over subjective marks creates an incentive to inflate valuations. Lower leverage, more cash and extra disclosure would not raise fees, so they are not the conflict created.

Did you get it right without looking?

One question tells you little. A timed set on Risk, Regulation and Organizational Structure shows your real accuracy, how long you take and where you lose marks.

Practise Risk, Regulation and Organizational StructureFree diagnostic mock

More Risk, Regulation and Organizational Structure questions