Risk Management and Value Creation in ... - Arabictrader.com

More documents

Recommendations

Info

Capital Budgeting in Banks 257 We have shown in Equation (6.13) that RAROC is a function of E(V A,T )/ EC and –I(1+R D )/EC, assuming still that I = V D, 0 , that is, the investment is fully funded by debt. Let us first consider negative NPV projects, that is, I > V A,0 . We examine the effects of a negative NPV on these two ratios that determine RAROC. We find that the change in the first of the two ratios when increasing risk will always outweigh the change in the second ratio, making RAROC an increasing function at a decreasing rate for negative NPV projects. 82 For positive NPV projects, that is, I < V A,0 , the change in the two ratios is more sophisticated. For low-risk projects, the change in the first ratio is smaller than in the second, making RAROC a decreasing function. For highrisk projects the reverse holds true. This leads to the following consequences: 1. For NPV = 0 projects, there is only one point where RAROC in combination with a bankwide hurdle rate leads to the right decision rule, namely to be indifferent about the investment. This consequence has already been described. Employees will have an incentive to choose high-risk, high-correlation projects that indicate value creation where there is none (this problem area is depicted gray in Figure 6.4). 2. For NPV < 0 projects, we will at least get the answer that their RAROC is smaller than the RAROC of the same project with NPV = 0. However, unless the bankwide hurdle rate is not consistently higher than the depicted RAROC curve, 83 the bank will create an even greater incentive to choose high-risk, high-correlation projects. As is shown in Figure 6.5, the gray shaded problem area lies further out to the right. 3. For NPV > 0 projects, we will again get the answer that their RAROC is higher than for NPV ≤ 0 projects. However, for NPV-positive projects, it could happen that a large number of positive NPV projects are rejected because their RAROC is below the bankwide hurdle rate, as indicated by the gray shaded area in Figure 6.6. As also indicated in Figure 6.6, this assumes that the hurdle rate is very high. Assuming this is not the case, RAROC will correctly indicate that projects add value because they are above the hurdle rate. However, when 82 Note that the change in the two ratios exactly offsets each other for NPV = 0 projects, making this function linear. 83 This situation might be very unlikely.
258 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS RAROC Hurdle Rate Risk Figure 6.4 Problem areas applying the RAROC decision rule: Zero NPV projects. Note: Results for plotting this graph are derived similar to Crouhy et al. (1999), especially Table 4, p. 19. transforming these results into economic profits, this obviously will indicate the wrong amount of value added to the bank. 84 We have highlighted the problem areas of applying the RAROCdecision rule in Figures 6.4 to 6.6 by shading them in gray. They reflect situations in which the bank either decides to undertake investments that are deemed to create value on a RAROC basis where there is none (or there is even value destruction; see Figure 6.5) or to reject projects that have a positive NPV, but are found to be value-destroying under the RAROC rule. 85 A bank therefore needs to decide whether it would like to accept these often only slightly wrong incentives induced when applying a simple decision rule (i.e., RAROC in combination with a bankwide hurdle rate), or 84 Even though economic profit is positive in this case, this will not reflect the correct NPV of the project and does not allow for a correct relative ranking of the projects. 85 Note that by using the adjusted RAROC proposed by Crouhy et al. the problem areas are eliminated. But on an economic profit basis, the adjustment does not lead to correct results (as proxy for NPV) nor to a correct relative ranking.
Page 2:
isk management and value creation i
Page 5 and 6:
Copyright © 2002 by John Wiley & S
Page 8 and 9:
preface From an empirical as well a
Page 10:
acknowledgments No book is solely t
Page 13 and 14:
x CONTENTS Goals of Risk Management
Page 15 and 16:
xii CONTENTS Definition of RAROC 24
Page 17 and 18:
xiv FIGURES Figure 5.5 Figure 5.6 F
Page 19 and 20:
symbols ↑ ↓ α β i xvi Increas
Page 21 and 22:
xviii SYMBOLS ln Natural logarithm
Page 23 and 24:
abbreviations APT BIS bn bps CAPM C
Page 25 and 26:
2 RISK MANAGEMENT AND VALUE CREATIO
Page 27 and 28:
Page 29 and 30:
Page 32 and 33:
CHAPTER 2 Foundations for Determini
Page 34 and 35:
Foundations for Determining the Lin
Page 36 and 37:
Page 38 and 39:
Page 40 and 41:
Page 42 and 43:
Page 44 and 45:
Page 46 and 47:
Page 48 and 49:
Page 50 and 51:
Page 52 and 53:
Page 54 and 55:
Page 56 and 57:
Page 58 and 59:
Page 60 and 61:
Page 62 and 63:
Page 64 and 65:
Page 66 and 67:
Page 68 and 69:
Page 70 and 71:
Page 72 and 73:
Page 74 and 75:
Page 76:
Page 79 and 80:
56 RISK MANAGEMENT AND VALUE CREATI
Page 81 and 82:
Page 83 and 84:
Page 85 and 86:
Page 87 and 88:
Page 89 and 90:
Page 91 and 92:
Page 93 and 94:
Page 95 and 96:
Page 97 and 98:
Page 99 and 100:
Page 101 and 102:
Page 103 and 104:
Page 105 and 106:
Page 107 and 108:
Page 109 and 110:
Page 111 and 112:
Page 113 and 114:
Page 115 and 116:
Page 117 and 118:
Page 119 and 120:
Page 121 and 122:
Page 123 and 124:
100 RISK MANAGEMENT AND VALUE CREAT
Page 125 and 126:
Page 127 and 128:
Page 129 and 130:
Page 131 and 132:
Page 133 and 134:
Page 135 and 136:
Page 137 and 138:
Page 139 and 140:
Page 141 and 142:
Page 143 and 144:
Page 145 and 146:
Page 147 and 148:
Page 149 and 150:
Page 151 and 152:
Page 153 and 154:
Page 155 and 156:
Page 157 and 158:
Page 159 and 160:
Page 161 and 162:
Page 163 and 164:
Page 165 and 166:
Page 167 and 168:
Page 169 and 170:
Page 171 and 172:
Page 173 and 174:
Page 175 and 176:
Page 177 and 178:
Page 179 and 180:
Page 181 and 182:
Page 183 and 184:
Page 185 and 186:
Page 187 and 188:
Page 189 and 190:
Page 191 and 192:
Page 193 and 194:
Page 195 and 196:
Page 197 and 198:
Page 199 and 200:
Page 201 and 202:
Page 203 and 204:
Page 205 and 206:
Page 207 and 208:
Page 209 and 210:
Page 211 and 212:
Page 213 and 214:
Page 215 and 216:
Page 217 and 218:
Page 219 and 220:
Page 221 and 222:
Page 223 and 224:
Page 225 and 226:
Page 227 and 228:
Page 229 and 230: 206 RISK MANAGEMENT AND VALUE CREAT
Page 279: 256 RISK MANAGEMENT AND VALUE CREAT
Page 316 and 317: eferences Aguais, Scott D., and Ant
Page 318 and 319: References 295 Blanden, Michael (19
Page 320 and 321: References 297 and Abuses,” Journ
Page 322 and 323: References 299 Froot, Kenneth A., a
Page 324 and 325: References 301 risiken aus Handelsg
Page 326 and 327: References 303 Investments in Stock
Page 328 and 329: References 305 Institute of Technol
Page 330 and 331:
References 307 Sharpe, William F. (
Page 332:
References 309 Wall, L.D., and John
Page 335 and 336:
312 INDEX Approach (continued) top-
Page 337 and 338:
314 INDEX Capital: Tier-1, 139, 146
Page 339 and 340:
316 INDEX Credit: derivatives, 178,
Page 341 and 342:
318 INDEX Expectations: homogeneous
Page 343 and 344:
320 INDEX Incentive(s), 22, 33, 45,
Page 345 and 346:
322 INDEX Managers, poorly diversif
Page 347 and 348:
324 INDEX Overinvestment, 75, 79, 8
Page 349 and 350:
326 INDEX Reserve(s) (continued) lo
Page 351 and 352:
328 INDEX Risk, liquidity, 3, 165 R
Page 353 and 354:
330 INDEX Sharpe ratio, 244, 252 Sh
Page 355:
332 INDEX Value at risk (VaR) (cont
show all

Risk Management and Value Creation in ... - Arabictrader.com

You also want an ePaper? Increase the reach of your titles

Delete template?

Save as template?