Dear All,
I was trying to build a RAROC model for Bonds and found few issues or concerns:
1. RAROC = Adjusted Income / Capital at Risk
2. Adjusted Income = (Yield - Cost of Funds - Op. Cost - EL ) * (1- Tax rate)
3. Capital at Risk = UL
4. I used the Moodys data for PD and LGD and thus was able to arrive at EL.
5. For UL I used the formulae (SQRT (PD* (1-PD))) * LGD
6. Yield is the current yield on the bond.
7. For Cost of Funds I used the internal Cost of Funds I am charged as a bond trader by my Funding Desk
8. For operating Cost I tried to use a proxy. I took the balance sheet of the firm and calculated the Operating Cost to Interest Income ratio from the Income statement. I used this ratio and multiplied it with the yield on the bond to arrive at Op. Cost , Is this fair? or is there a better way to arrive at Op. Cost?
Do you think I am correct with the above calculations?
Also I find it difficult when I try to calculate the RAROC for a Fixed Rate bond and a Floating Rate bond? Do I use the All in Yield or Z-Spreads?
Let me try to explain with an example.
Consider the following 2 bonds from JP Morgan.
Bond 1 - Fixed Rate bond, ISIN US48126EAA55, Maturity date - 15 Aug 2017, Coupon 2%, Current Price 100.28 thus Yield is 1.93%, Rank - Senior Unsecured
Bond 2 - FRN, ISIN US46623EJQ35, Maturity date - 6 September 2017, Coupon - USD 3M Libor + 110 bp, Current Price 101.089, Discount Margin - 83 bp (All in yield = Discount margin + 3m USD Libor = 1.1%), Rank - Senior Unsecured.
Now since both these bonds are around 4 years of remaining maturity and Sr Unsecured bond, as per Moodys Report "Annual Default Study Corporate Default and Recovery Rates 1920-2012" , the PD is 0.99% and LGD is 63%.
I assume it is fair to take PD and LGD same for both these bonds ?
Lets assume my Cost of Fund as 3M USD Libor + 25 bp and my Op. Cost at 30% of my All in yield. Assume Tax at 30%.
On Computing my RAROC for both these bonds, the RAROC for bond 1 is 2.30% while RAROC for bond 2 is -5.30%, and i can understand the reason for the difference being the all in yield as it is higher "currently" for the fixed rate bond while lower for FRN but the FRN is not exposed to interest rate risk while the fixed rate bond is.
Intuitively I know the calculation above is not correct? Could you suggest how i can better this model?
Also I am comparing the RAROC with the ROE which is available from Financial Statement or research reports. Hope thats fine?
Regards
I was trying to build a RAROC model for Bonds and found few issues or concerns:
1. RAROC = Adjusted Income / Capital at Risk
2. Adjusted Income = (Yield - Cost of Funds - Op. Cost - EL ) * (1- Tax rate)
3. Capital at Risk = UL
4. I used the Moodys data for PD and LGD and thus was able to arrive at EL.
5. For UL I used the formulae (SQRT (PD* (1-PD))) * LGD
6. Yield is the current yield on the bond.
7. For Cost of Funds I used the internal Cost of Funds I am charged as a bond trader by my Funding Desk
8. For operating Cost I tried to use a proxy. I took the balance sheet of the firm and calculated the Operating Cost to Interest Income ratio from the Income statement. I used this ratio and multiplied it with the yield on the bond to arrive at Op. Cost , Is this fair? or is there a better way to arrive at Op. Cost?
Do you think I am correct with the above calculations?
Also I find it difficult when I try to calculate the RAROC for a Fixed Rate bond and a Floating Rate bond? Do I use the All in Yield or Z-Spreads?
Let me try to explain with an example.
Consider the following 2 bonds from JP Morgan.
Bond 1 - Fixed Rate bond, ISIN US48126EAA55, Maturity date - 15 Aug 2017, Coupon 2%, Current Price 100.28 thus Yield is 1.93%, Rank - Senior Unsecured
Bond 2 - FRN, ISIN US46623EJQ35, Maturity date - 6 September 2017, Coupon - USD 3M Libor + 110 bp, Current Price 101.089, Discount Margin - 83 bp (All in yield = Discount margin + 3m USD Libor = 1.1%), Rank - Senior Unsecured.
Now since both these bonds are around 4 years of remaining maturity and Sr Unsecured bond, as per Moodys Report "Annual Default Study Corporate Default and Recovery Rates 1920-2012" , the PD is 0.99% and LGD is 63%.
I assume it is fair to take PD and LGD same for both these bonds ?
Lets assume my Cost of Fund as 3M USD Libor + 25 bp and my Op. Cost at 30% of my All in yield. Assume Tax at 30%.
On Computing my RAROC for both these bonds, the RAROC for bond 1 is 2.30% while RAROC for bond 2 is -5.30%, and i can understand the reason for the difference being the all in yield as it is higher "currently" for the fixed rate bond while lower for FRN but the FRN is not exposed to interest rate risk while the fixed rate bond is.
Intuitively I know the calculation above is not correct? Could you suggest how i can better this model?
Also I am comparing the RAROC with the ROE which is available from Financial Statement or research reports. Hope thats fine?
Regards
