# RAROC calculation

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

1. ### ckyehNew 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. ### David Harper CFA FRM CIPMDavid Harper

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

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 2011New 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. ### David Harper CFA FRM CIPMDavid Harper

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