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

A manager claims a strategy that requires buying and selling S&P 100 options in sizes that, by the analyst's estimate, exceed the total open interest and daily volume in the relevant listed contracts. Which is the most appropriate due diligence response?

The mismatch between the trade sizes needed and the available option market is a red flag. The analyst should independently verify trades through counterparties and the clearing broker instead of relying on the manager, because the strategy as described may not be executable at that scale.

  1. AAccept the claim because over-the-counter trades are never verifiable
  2. BTreat the capacity mismatch as a red flag and seek independent trade confirmations from counterparties and the clearing brokerCorrect
  3. CReduce the allocation slightly but rely on the manager's own statements
  4. DConclude the strategy is simply highly scalable

Explanation

If required option volumes exceed what the market can supply, the strategy cannot be executed as described. The analyst should independently verify trades with counterparties and custodians rather than relying on the manager. Accepting manager statements ignores the inconsistency.

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