RAROC calculation

Discussion in 'P2.T7. Operational Risk & ERM (25%)' started by ckyeh, Oct 18, 2010.

  1. ckyeh

    ckyeh New Member

    Dear David:
    On your webinar 「2010-7-a-Operational」 page 8:
    Define, compare and contrast economic and regulatory capital.
    What is the meaning of Common risk currency?

    And another question, On your webinar 「2010-7-a-Operational」 page 9:
    The calculation of RAROC:
    Loan is funded with deposits that earn (a deposit charge of) 5%.
    Here the loan is $1 billion. We got COF(Cost of Fund)=1,000MM*5%=50MM
    However, on the book 「Risk Management」, Chapter 14 –Capital Allocation and Performance Measurement, Page 533:
    Crouhy use $925 million ($925 million = Loan – Economic Capital = $1 billion-$75 million), not simply the loan $1 billion to calculate COF.
    Should I minus the Economic Capital to calculate COF?

    Many Thanks
  2. Hi ckyeh,

    In regard to common risk currency, can I recommend my brief note @
    http://www.bionicturtle.com/how-to/webinar/economic_capital_webinar_notes/
    … which links to a presentation that I like a lot: http://www.scribd.com/doc/18553899/Economic-Capital-a-Common-Currency-for-Risk

    In regard to the RAROC, you are looking at an earlier print of his book.
    We first discovered Crouhy's error of $925 (and forward to him) three years ago
    (http://www.bionicturtle.com/forum/viewthread/44/)
    … such that later prints do fund the liabilities with $1 billion
    (http://www.bionicturtle.com/forum/viewthread/664/)

    So, the revised view (as per my XLS) is to fund with liabilities equal to the loan. In this case, correct is to use $1 billion.
    (My learning XLS 7.a.1 @ http://www.bionicturtle.com/how-to/spreadsheet/7.a.1_raroc_crouhy/
    Actually labels a "Crouhy v1" which is your print and the revised "Crouhy v2" because there can still be a debate about it. But safe is $1 BB.)

    David
  3. FRM Candidate 2011

    FRM Candidate 2011 New Member

    Hello David

    Makes sense what you write, since the loan has to be fully funded and the EC is set aside (otherwise it also couldn´t earn a return, since the actual cash is with the borrower...).

    In your study notes (Operational and Integrated Risk Management) on page 5 however, you also deduct the EC from the loan in the first example, ie COF= (1bn - 50 Mio) *5% = 47.5 Mio.

    To be consistent this number should be 1bn * 5% = 50 Mio

    Regards

    Christian
  4. Hi Christian,

    Yes, i totally agree. Frankly, that was a legacy example (i.e., based on the first print of Crouhy) that I just failed to correct. Thank you! David

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