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

A risk manager at a fund of funds is drawing lessons from the Madoff case about verification of trades. Which procedure would most directly have exposed the fraud that regulators failed to detect?

Directly confirming trades and holdings with independent third parties, such as the Options Clearing Corporation and the Depository Trust Company, would have exposed the fraud, because the trades never existed. Reviewing documents or statements supplied by Madoff himself relies on the party perpetrating the fraud.

  1. AComparing Madoff's reported returns with an equity market index to check for a positive beta
  2. BReviewing the strategy description in the offering memorandum for consistency
  3. CConfirming trade and holdings records directly with independent third parties such as the Options Clearing Corporation and the Depository Trust CompanyCorrect
  4. DRequesting a monthly performance letter signed by the fund's principal

Explanation

Madoff's trades did not exist, so independent confirmation with clearing and custody entities would have shown no matching activity. Reviewing documents or letters supplied by Madoff relies on the very party committing the fraud. A beta check does not verify the existence of trades.

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