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

A hedge fund uses a single in-house pricing process in which the portfolio manager supplies marks for illiquid positions, and the manager's incentive fee depends on reported NAV. Which risk is most directly heightened by this structure?

Valuation risk from a conflict of interest is most heightened. The manager who earns incentive fees on NAV also sets prices for illiquid holdings, creating an incentive to overstate values. Independent valuation separate from the front office is the standard remedy.

  1. AValuation risk arising from a conflict of interest between the manager and investorsCorrect
  2. BBasis risk between the fund and its benchmark
  3. CInterest rate risk from duration mismatch
  4. DCounterparty risk from prime broker concentration

Explanation

When the person who benefits from higher NAV also determines the marks of illiquid positions, there is an incentive to overstate values, which inflates fees. The remedy is independent valuation by a function separate from the front office. The other risks are not created by this pricing arrangement.

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