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

A feeder fund reports that its manager bought a basket of S&P 100 stocks and options whose notional is 5 billion. The listed S&P 100 index option open interest that could hold such collars is only 2 billion in equivalent notional. What is the most appropriate due diligence conclusion?

The claimed option positions exceed the listed market's capacity, so the strategy cannot be verified as described. Due diligence should escalate, demand counterparty and trade confirmations, and decline to invest if they cannot be obtained. Assuming OTC trading or leverage without evidence would repeat the Madoff oversight.

  1. AThe manager is probably trading over-the-counter, so no further checks are needed
  2. BThe claimed positions exceed available market capacity, so the strategy cannot be verified and warrants escalation or avoidanceCorrect
  3. CThe discrepancy shows the manager is hedging more than required, which reduces risk
  4. DThe difference is explained by leverage and is therefore acceptable

Explanation

Claimed option positions of 5 billion versus 2 billion of listed capacity implies the trades would exceed the market, as was alleged for Madoff. OTC trading would require counterparty confirmation, not assumption. Leverage or extra hedging do not explain it away. The correct response is to demand verification of counterparties and trade records and to escalate or decline to invest.

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