30. Capital management III

Question 1

What is the formula for RAROC

Answer 1

Risk adjusted return / capital

*Risk adjusted return = Expected revenue - costs - losses + ROC - tax

Question 2

What is the formula for EIC

Answer 2

(RAROC-hurdle rate) ×capital

Question 3

Which factors must you consider when setting the hurdle rate

Answer 3

• Cost of capital
• Inherent risks in proposal but allow for diversification and hedging

Question 4

What is shareholder value?

Answer 4

• Present value of future cashflows
  SHV=capital×((RAROC-g)/(hurdle-g))

Question 5

What is chareholder value added

Answer 5

• Excess over capital invested

Question 6

What considerations must org take when allocating capital?

Answer 6

• What capital must be allocated?
• Allowing for diversification / concentration risk
• Coherence of selected risk measure
• Using diff risk measures to calculate overall requirement and requirement at unit level
• Allocatin excess capital
• Allocations change significantly over time
• Communicating complex and potentially unintuitive results

Question 7

Outline the principles of capital allocation

Answer 7

• Purpose
• Desirable outputs of results, e.g., stability over time
• Methods

Question 8

Factors to consider when comparing capital allocation methods

Answer 8

• Complexity and computational intensity
• Ease of communication
• Degree to which allocation is affected by presence of other business units
• Degree to which allocation is affected by basis (e.g., order in mrginal approach)
• Degree to which method can lead to under-investment in business units providing a diversification benefit (eg standalone)
• Degree to which method can lead to over-investment in business units (e.g., pro rata)
• Correspondence with marginal pricing principle

Question 9

List methods to calculating how much capital to allocate

Answer 9

• Central and not allocating to units
• Risk measure
• Marginal approach
• Game theory
  *Pro-rata
• Stand-alone

Question 10

Examples of risk measure approaches to allocating capital

Answer 10

• Euler principle
• Proportional spread
• Complex numeric implementation models

Question 11

Explain the marginal approach to allocating capital

Answer 11

• Each unit receives the change in capital as a result of adding it to a diversified portfolio
• May result in diff capital allocations depending in the order in which analysis is done
• Diff results may be averaged to derive final figures

Question 12

Explain the game theory approach to allocating capital

Answer 12

• Shapley method allocates capital w/reference to ave of marginal capital requirements assumin unit is added 1st, 2nd etc
• Ensures equality between units regardless of order
• Computationally intensive

Question 13

Explain the pro-rata approach to allocating capital

Answer 13

• Use basis to allocate capital e.g. premiums/reserves
• If not risk based, large capital may be allocated to low risk units

Question 14

Stand-alone basis

Answer 14

• Treat units in isolation
• No diversification effects