This section presents the current mind-set with regard to risk management in FoFs (which also extends to hedge funds).

38.6.1 Institutional-Grade Risk-Management Policy: Is It Possible in Practice?

Any robust institutional investment process must be complemented with a proper risk-management policy. The vast array of possible trading strategies and the ability to employ leverage and derivatives make evaluating the risk associated with hedge fund investments (or, for that matter, a portfolio of hedge funds or FoFs) a challenging task.

An investment committee's due diligence on a hedge fund typically consists of following a predetermined process. While this process may vary across investors, it frequently includes examining the portfolio manager's background, the organizational structure of the fund, legal documents (e.g., private placement memorandum and subscription documents), and the internal risk-management policy.

The examination of the risk-management policy often includes looking at the current portfolio's risk characteristics as summarized on recent prime-broker or third-party risk-aggregation reports, or even reviewing the actual underlying positions. Additionally, policy limits may exist on the position, sector/industry, and gross/net exposures. Finally, quantitative analysts use a number of other risk measurements, including value at risk (VaR), conditional VaR, stress tests, DV01s, and Greeks. A DV01 is the dollar value of an oh-one, which is the ...

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