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

Why do Ponzi schemes like Madoff's typically collapse during periods of market stress?

They collapse because redemptions surge while new inflows stop. A Ponzi scheme pays old investors with new investors' money and holds little real assets, so when stress raises withdrawals and shrinks inflows, it cannot meet payouts and the fraud is exposed.

  1. ARedemption requests rise while new inflows dry up, exposing the lack of real assets to pay investorsCorrect
  2. BReal trading profits fall below the promised return, triggering automatic liquidation
  3. CRegulators routinely raise capital requirements for all advisers in downturns
  4. DFee income increases beyond what investors will tolerate

Explanation

A Ponzi scheme relies on new money to fund redemptions. In stress, investors withdraw more and fewer new investors arrive, so the scheme cannot meet payouts. Madoff's collapse in 2008 followed this pattern.

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