Learning Objectives: Compute and interpret the RAROC for a project, loan, or loan portfolio, and use RAROC to compare business unit performance. Explain challenges that arise when using RAROC for performance measurement, including choosing a time horizon, measuring default probability, and choosing a confidence level. Calculate the hurdle rate and apply this rate in making business decisions using RAROC.
Questions:
24.12.1. Ant Commercial Bank is considering a loan with the following parameters that would be fully funded by deposits:
a. 10.83%
b. 17.75%
c. 2.17%
d. 13.88%
24.12.2. Leo, a CRO at Inquisitive Bank, has been asked to note for significant challenges with using Risk-Adjusted Return on Capital (RAROC) as a performance measure. He notes down the following, in his summary to the Board:
a. Only statement 1
b. Only statement 3
c. Only statement 2
d. All three are NOT correct
24.12.3. The CFO of Avenues Lending has requested the calculation of the hurdle rate for dissemination to loan portfolio managers as part of the Loan Portfolio department's annual appraisal. Given a RAROC of 6.8%, the market value of Common Equity stands at $200 million, and the Market Value of Preferred Equity is $800 million.
After conducting a market study, the following information is available:
What should the hurdle rate be, and what is the implication?
a. 8.75%, the department is generating sufficient returns to cover the cost of capital
b. 6.55%, the department is not generating sufficient returns to cover the cost of capital
c. 8.75%, the department is not generating sufficient returns to cover the cost of capital
d. 6.55%, the department is generating sufficient returns to cover the cost of capital
Answers here:
Questions:
24.12.1. Ant Commercial Bank is considering a loan with the following parameters that would be fully funded by deposits:
- Loan amount: $100 million
- Average annual interest rate paid on deposits: 0.5%
- Annual interest rate received on loan: 6.5%
- Expected loss: 1% of face value of loan
- Annual operating costs: 2% of face value of loan
- Economic capital required to support the loan: 20% of the loan amount
- Average pre-tax return on economic capital: 4%
- Effective tax rate: 30%
- Other transfer costs: 0.25%
a. 10.83%
b. 17.75%
c. 2.17%
d. 13.88%
24.12.2. Leo, a CRO at Inquisitive Bank, has been asked to note for significant challenges with using Risk-Adjusted Return on Capital (RAROC) as a performance measure. He notes down the following, in his summary to the Board:
- Statement 1: Choosing a longer time horizon for RAROC calculations might not accurately reflect the immediate effectiveness of recent strategic decisions, potentially diluting the perceived impact of short-term risk management actions.
- Statement 2: Utilizing a Point-in-Time (PIT) approach to estimate default probabilities can lead to high variability in RAROC outcomes due to its sensitivity to immediate economic conditions, thereby complicating the distinction between genuine risk profile changes and external economic fluctuations.
- Statement 3: A lower confidence level in the RAROC calculation reduces the variability of economic capital, thereby stabilizing the return on equity measurements and providing a more conservative assessment of risk exposure.
a. Only statement 1
b. Only statement 3
c. Only statement 2
d. All three are NOT correct
24.12.3. The CFO of Avenues Lending has requested the calculation of the hurdle rate for dissemination to loan portfolio managers as part of the Loan Portfolio department's annual appraisal. Given a RAROC of 6.8%, the market value of Common Equity stands at $200 million, and the Market Value of Preferred Equity is $800 million.
After conducting a market study, the following information is available:
- Beta: 1.25
- Market return: 8%
- Risk-free rate: 5%
- Dividend on preferred shares: $48 million
What should the hurdle rate be, and what is the implication?
a. 8.75%, the department is generating sufficient returns to cover the cost of capital
b. 6.55%, the department is not generating sufficient returns to cover the cost of capital
c. 8.75%, the department is not generating sufficient returns to cover the cost of capital
d. 6.55%, the department is generating sufficient returns to cover the cost of capital
Answers here:
