Aug 04

New OpRisk learning spreadsheets

by David Harper, CFA, FRM, CIPM

I uploaded five new learning spreadsheets to the member page. They are associated with next Monday’s screencast tutorial (Operational Risk B). Only the RAROC is highlighted; it is the only one I recommend. The others are merely offered “as-needed” to clarify difficult concepts. The new EditGrid spreadsheets are:

Optimal WACC/firm value illustration. This illustrates Stulz’ point that a firm has an optimal capital structure. Under this view, an all-equity financed firm is sub-optimal because equity is more expensive than debt. An increase in leverage lowers WACC and increases firm value. But as leverage increases, the firm incurs the costs of financial distress.
Hedging Price Risk: a simple illustration of Rene Stulz gold mining company (Highly Levered Gold) and how hedging against price risk does not increase firm value. This might be useful because the numerical illustration is much simpler than the text
Debt overhang: illustrates why debt overhang may discourage a firm from making a profitable investment
Risk-adjusted return on capital (RAROC): Crouhy’s example. Simple.
RAROC problem: I replicated the argument against first-gen RAROC in favor of second-generation RAROC. In short, first gen RAROC implies a firm has the same hurdle rate for all projects; riskier projects (with higher expected return) will be favored even as PD is unchanged. That is the puzzle: PD can be constant (at, say 1%), but ROE will increase with volatility/systemic correlation; or conversely, if ROE is constant, PD can be changing. In short, ROE is “biased” or influenced by risk. Advanced only.