FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
A fund of funds is evaluating a manager who says the strategy trades equity index options with a notional that the due diligence team estimates would require option volume exceeding the total open interest in the relevant listed contracts. The manager explains that the trades are executed over the counter with unnamed European counterparties. Which is the most appropriate conclusion?
The claimed option volume exceeding observable market capacity, combined with unnamed OTC counterparties, is a strategy red flag. It should be independently verified through counterparty confirmations and trade records before investing, since secrecy prevents verification and positive returns do not validate the strategy.
- AThe strategy capacity claim is credible because OTC markets have no volume limits
- BThe claimed scale versus observable market capacity is a strategy red flag, and the claim should be independently verified through counterparty confirmation and trade records before any investmentCorrect
- CThe scale is acceptable if the auditor is a small firm
- DThe strategy should be accepted because the manager's returns are positive
Explanation
Strategy capacity relative to market depth is a standard check. Unnamed counterparties prevent verification, and a size exceeding observable open interest cannot be assumed away by moving to OTC. Independent confirmation of trades and counterparties is the appropriate response, while positive returns do not validate the claim.
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