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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

A due diligence team finds that a fund claiming to trade S&P 100 stocks and index options reports that its option positions would have required notional volume exceeding the total open interest in the listed S&P 100 options market. What is the most appropriate interpretation?

A strategy that would need option volume beyond the whole listed market's open interest is not feasible at that scale. This is a strategy capacity red flag, and any OTC explanation must be independently verified with counterparties rather than simply accepted.

  1. AThe manager is probably using over-the-counter options, so the claim is fully explained
  2. BThe strategy as described appears infeasible at its reported scale, which is a strategy capacity red flagCorrect
  3. CThe excess is a normal result of leverage in options strategies
  4. DThe finding is irrelevant if reported returns are stable

Explanation

If required trades exceed the market's total capacity, the stated strategy cannot be executed as described. While OTC options could be a possible explanation, it must be verified through counterparties and confirmations rather than assumed. Stable returns do not cure an infeasible strategy.

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