Skip to content

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

In a Ponzi scheme such as Madoff's, which mechanism best explains how the operator can keep paying redemptions to investors while no genuine trading profits are generated?

The operator uses cash from new investors to pay redemptions and reported returns to earlier investors. No real trading profit supports the payouts, so the scheme survives only while inflows cover withdrawals and collapses when redemptions exceed new money, as happened during the 2008 crisis.

  1. AHedging the portfolio with offsetting option positions
  2. BUsing cash from new investor inflows to pay earlier investors' redemptions and reported returnsCorrect
  3. CLending client securities to prime brokers to earn fees
  4. DReinvesting dividends from a diversified equity portfolio

Explanation

A Ponzi scheme depends on new money to meet payouts to existing investors. It becomes insolvent when redemption requests exceed new inflows, as occurred in late 2008. The other choices describe legitimate sources of return that were not actually generating the reported profits.

Did you get it right without looking?

One question tells you little. A timed set on Madoff: A Riot of Red Flags shows your real accuracy, how long you take and where you lose marks.

Practise Madoff: A Riot of Red FlagsFree diagnostic mock

More Madoff: A Riot of Red Flags questions