RAROC Hurdle rate

[sridhar]

I am watching your OpRisk Part B and the section on RAROC and adjusted RAROC. You say that in the first generation RAROC, you compute the RAROC and compare it to a "hurdle rate" and then if the RAROC os greater then you go ahead with some risky project.

1. What is "hurdle rate" and what is it associated with? (e.g. firm's value?)

2. Who determines or sets this hurdle rate?

--sridhar

 

[David Harper CFA FRM]

Hi sridhar-

Traditionally (i.e., first generation RAROC), as this is essentially similar to economic value added (EVA), the test is:

is RAROC > cost of equity capital (COE)? if so, it is a good project, and the project adds value

(EVA starts with ROC and WACC; i.e., includes debt. But no mattter, it is easy to show they get the same place. The above is cost of EQUITY not cost of capital)

So, the hurdle is cost of equity capital. This could be firm-wide or delegated (budgeted) to divisions/BUs.

Who determines or sets? It is estimated by management and/or with Board consult/approval, firm depending. Comes from the top, finance generates for management. Firm practices will vary. I used to do these as a consultant; ex ante it can only be estimated. No magic lookup number, several folks can get different numbers for the same firm (e.g., based on dataset). In my experience, despite two decimal precision and scientific methods, estimating cost of equity always contains a subjective component.

A popular method is to use the CAPM or multi-factor variants as the expected return via CAPM in theory should be the cost of equity capital (insert here all sorts of drawbacks and issues, including the drawback that leads to second generation RAROC: failure to account for the new project's systematic risk)

David