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

An analyst wants to test whether a manager's claimed split-strike conversion strategy was actually being implemented. Which check would be most informative and consistent with lessons from the Madoff case?

Replicating the claimed strategy using actual market prices and option data and comparing it with the reported returns is most informative. It provides independent evidence of plausibility. In Madoff's case, the reported returns and the option volume needed could not be reconciled with real markets.

  1. AComparing the fund's reported monthly returns to a simple replication of the strategy using actual market prices and option dataCorrect
  2. BConfirming that the manager has a long operating history
  3. CReviewing the marketing brochure for the strategy description
  4. DAsking the manager whether the fund has ever had a losing year

Explanation

Replicating the strategy with market data tests whether reported returns are plausible, and in the Madoff case the claimed trades could not have produced the returns, and option volume needed exceeded the market's total. Track record, brochures and manager statements are not independent evidence.

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