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Chapter 13

Risk-Adjusted Return on Capital


Models
Definition of RAROC

AdjustedIncome
RAROC = CapitalatRisk

• If RAROC > Hurdle rate then value adding.


• ROA = AdjustedIncome
AssetsLent

• RORAC = AdjustedIncome
Risk  basedCapital Re quirement

• EVA = economic value added = Adjusted


income – ROE x K. Invest if  0.
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The Numerator: Adjusted Income
• = Spread (direct income on loan) +
• + Fees (directly attributable to loan) –
• - Expected Loss (EDF x LGD) –
• - Operating Costs (allocated to loan)
• Then multiply the entire amount by 1 – the
marginal tax rate.

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The Denominator: Capital at Risk
• Market-based approach (BT model)
– Measure the maximum adverse change in the
market value of the loan resulting from an
increase in the credit spread
– Use duration model to measure price effects.
• Experientially-based approach (BA model)
– Calculate UL using a multiple x LGD x
exposure x standard deviation of default rates.
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The Market-based Approach to
Measuring Capital at Risk
L = -DL x L x R/(1+RL) (13.9)

(Dollar capital risk (Duration (Risk amount or (Expected discounted change in


the
exposure or loss of the loan loan exposure) credit premuim or risk factor on
the
amount) loan)

• If DL=2.7, L=$1m, R=1.1%, R=10%, then:


L = -$ 27,000

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Figure 13.1 Estimating the change in the risk premium.

Frequency

1% of All AAA Bonds

 Risk 1% 0 1.1% 3.5%  Risk


Premium Premium
(R) (R)

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The Experientially-based Approach to
Capital at Risk Measurement
• If 99.97% VAR (AA rating) and normal
distribution, then the multiplier is 3.4.
• But, most banks use a large multiplier
because loan distributions are not normal.
• BA uses multiplier = 6.
• If LGD=.5, Exposure=$1m, Loan
=.00225, then UL=6 x .00225 x .5 x $1m
= $27,000 (same as market-based approach)
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Calculating the RAROC of the
Loan Example
• Spread = .2% x $1m = $2,000
• Fees = .15% x $1m = $1,500
• EL = .1% x $.5m = ($500)
• Tax rate = 0%
• Adjusted Income = $3,000
• RAROC = $3,000/$27,000 = 11.1%
• If cost of capital < 11.1% then make loan.
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The RAROC Denominator and Correlations

Ri – RF = i (Rm - RF) (13.15)


where Ri = the return on a risky asset,
RF = the risk-free rate,
Rm = the return on the market portfolio,
i = the risk of the risky asset,
and
i = im/2m = imim/2m = imi/m (13.16)
where im = covariance between the returns on risky asset i and the market portfolio m,
m = standard deviation of the return on the market portfolio,
im = correlation between the returns on the risky asset i and
the market
portfolio

Ri - RF = Rm - RF
imi m
RAROC = Hurdle Rate (13.18)

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Incorporating Unsystematic Risk
• Equation (13.18) is the traditional Sharpe ratio for a loan. But, if all
idiosyncratic risk is diversified away, then no need for RAROC.
RAROC deals with untraded and unhedgeable assets (loans).
• Banks specialize in info-intensive relationship lending that cannot be
hedged in capital markets. Risk of loan should be divided into: (1)
liquid, hedgeable market risk component and (2) illiquid, unhedgeable
component.
• The correlation of the unhedgeable component with the bank’s
portfolio will determine the loan’s price. So different banks (with
different portfolio correlations) will have different pricing (credit risk).
• Froot & Stein (1998): Loan’s hurdle rate =market price of the loan’s
traded risk + bank shareholders’ cost of capital to cover nontradeable
risk. The second term is idiosyncratic.

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