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

An analyst notes that a manager claims to buy a basket of large-cap equities and hedge with index options, with reported monthly returns that never fall below -0.5% and a track record of 15 years. The options needed for the hedge would have to exceed the entire listed open interest in the relevant index options market. What is the best interpretation under a sound due diligence framework?

The claimed hedge size conflicts with observable market capacity, so the stated trades cannot be accepted at face value and need independent verification, such as counterparty confirmations. Possible OTC use would itself require verification, and consistent returns do not offset an implausible strategy.

  1. AThe manager is likely using over-the-counter options, which fully explains the gap, so no further checks are needed
  2. BThe strategy's capacity claim is inconsistent with market data, so the claimed trades cannot be taken at face value and require independent verificationCorrect
  3. CThe gap is evidence of exceptional skill in sourcing liquidity
  4. DThe gap is irrelevant because returns are consistent

Explanation

Comparing claimed positions with observable market capacity is a basic plausibility test. A mismatch means the claims need independent confirmation of counterparties and trades. OTC use is possible but would itself need verification, so it cannot justify skipping checks.

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