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

A Ponzi scheme holds client balances of 1,000 million and promises annual returns of 10% that are never actually earned. In one year, investors redeem 150 million of principal and 100 million of promised gains is paid out, with no real investment income. If new inflows are 200 million, what is the change in the scheme's actual cash assets (ignoring the fictitious reported gains)?

The cash assets fall by 50 million. Inflows of 200 million are outweighed by outflows of 250 million (150 principal plus 100 gains paid), and fictitious reported gains add no real cash, so the scheme's shortfall widens.

  1. A-50 millionCorrect
  2. B+50 million
  3. C-250 million
  4. D+100 million

Explanation

Cash out = 150 + 100 = 250 million. Cash in = 200 million. Net change = 200 - 250 = -50 million. Reported gains of 100 million are fictitious and add no cash; adding them (+100) or ignoring the payout of gains are errors.

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