FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
A due diligence analyst reviews a hedge fund feeder that reports steady monthly returns near 1% with only a handful of down months over 15 years, attributed to a 'split-strike conversion' strategy. In the Madoff case, which feature of this return pattern was the most important quantitative red flag?
The key red flag was that returns were implausibly smooth for the stated split-strike conversion strategy. A collared equity portfolio should exhibit equity-market sensitivity and occasional sizeable losses, yet reported results showed very few down months, suggesting the numbers were not generated by the described strategy.
- AReturns were too consistent for the strategy's stated exposure to equity markets and option payoffsCorrect
- BReturns were too volatile relative to Treasury bills
- CReturns were negatively correlated with the S&P 100 in every month
- DReturns were identical to the risk-free rate in every month
Explanation
A split-strike conversion holds equities and uses collars, so returns should show meaningful equity beta and drawdowns in bad markets. Smooth positive returns with very few losing months were inconsistent with the stated strategy. The other options misstate the actual pattern: returns were not negatively correlated in every month, nor identical to T-bills.
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