FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
Why does a Ponzi scheme such as Madoff's typically collapse during a market crisis or a wave of redemptions?
A Ponzi scheme pays redemptions from new investor deposits rather than real profits. When a crisis cuts inflows and increases withdrawal requests, cash runs out and obligations cannot be met, which is how Madoff's scheme collapsed in late 2008.
- ARegulators automatically freeze all hedge funds in a crisis
- BPayments to redeeming investors depend on new inflows, so when inflows fall below redemptions the scheme cannot meet its obligationsCorrect
- COption premiums become too cheap to fund the strategy
- DInvestors' reported returns suddenly turn negative from trading losses
Explanation
A Ponzi scheme earns no genuine returns, so redemptions are funded by new investor money. In a crisis, inflows dry up and redemption requests surge, creating a liquidity gap that cannot be closed. The other options do not describe the mechanism.
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