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

A Ponzi scheme has 1,000 of investor capital at the start of a year and promises 10% returns. It earns no actual profit. Investors withdraw 15% of their account balances (including promised returns) at year-end, and no new money arrives. Assuming balances are credited with the promised return before withdrawals, what is the scheme's actual asset shortfall relative to reported liabilities after the withdrawals?

The shortfall is 100. Reported balances grow to 1,100, but real assets stay at 1,000 because no profit is earned. A 165 withdrawal reduces both sides equally, leaving reported liabilities of 935 against assets of 835, so the fictitious 100 gain remains as the gap.

  1. A100
  2. B85Correct
  3. C150
  4. D0

Explanation

Reported balances = 1,000 x 1.10 = 1,100. Withdrawals = 15% x 1,100 = 165, paid from actual assets of 1,000, leaving assets of 835. Reported liabilities after withdrawals = 1,100 - 165 = 935. Shortfall = 935 - 835 = 100. Check: shortfall equals the fictitious 100 of gains, which is unaffected by withdrawals, so the answer is 100.

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