Ch6 Economic Capital & Capital Allocation (2)

1. Risk-Adjusted Performance Measures
1-1. RAROC(risk-adjusted return on capital)

1-1-1. Definition: http://investopedia.com/terms/r/raroc.asp

A risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consisten view of profitability across business.

1-1-2. Video lecture: http://www.youtube.com/watch?v=JUF-UScpEqs&feature=PlayList&p=B2510265C0BDC43A&index=0&playnext=1



1-1-3. Charateristics
- used to determine the appropriate capital charge to add to the pricing process
- used to compare assets with different risk characteristics
- uses a worst-case scenario approach to estimate the future value of an asset => produces the capital cushion necessary to provide for the potential loss
- based on the mark to market concept of holding more capital for assets

1-1-4. Basic Steps
Step 1. Determine the basic risk categories for the asset
- interest rate (country, directional, basis, yield curve, optionality), foreign exchange, equity, commodity, credit, & operating risk
Step 2. Use a market proxy to quantify the relative risk in each category
Step 3. Compute a market risk factor
Step 4. Compute capital required for each risk category

RAROC risk factor = 2.33 x weekly volatility x SQRT(52) x (1 - tax rate)

e.g.) 99% confidence level: 2.33, weekly volatility: 3%, tax rate: 30%, asset value:$50M
=> RAROC riskfactor = 2.33 x 3% x Sqrt(52) x (1 - 30%) = 35.28%
Capital Charge = $50M x 35.28% = $17.64M

**capital charge: a measure of portfolio risk based on an expected loss, considering the default frequency and loss severity (relative duration & magnitude)
The capital charge is in response to the risk of an adverse movement in the value of an insurer's on-balance sheet assets and/or certain off-balance sheet obligations. It covers the risks to hold an amount of capital against each asset that is proportional to the value of that asset.

1-1-5. Drawback of RAROC
RAROC does not consider correlations among individual assets when used to analyze the risk profile of a portfolio ==> RAROC2020



2. VaR
2-1. Challenges in Calculating VaR
- VaR utilize a return's variance/covariance matrix => problem: asset value change in a nonlinear manner (e.g. embedded options) => RiskMetrics
- RiskMetrics: the lack of continuous price data for many bank assets



3. Economic vs. Regulatory Capital
3-1. Economic Capital: the amount of capital that management determines to be necessary to cushion losses from an asset.

3-2. Regulatory Capital: designed to apply to various types of firms and is not based on borrower risk

3-3. Characteristics of EC Allocation Process
- Is integral as part of a well-defined management process
- Has shareholder-wealth maximization as its central theme.
- Is comprehensive in its inclusion of all risks and activities
- Is in harmony with the existing corporate-risk governance structure
- Applies both quantitative and qualitative analytic techniques
- Is comprehensible, adequately controlled, and communicated internally
- Is highly regarded by decision makers as a reliable tool