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

264 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
discussed in the previous chapter). We further assume that this class of debt
provides its own contribution to the (asset) insurance pool. The value of this
“note insurance” can be determined by the value of the put option, as shown
in Equation (6.4) and is equal to the amount that is necessary to insure the
debt (tranche) up to a level so that it is virtually risk-free. 103 It is represented
as the dark gray box in the left-hand part of Figure 6.8.
Moreover, we assume that the difference between the required amount
of economic capital EC and the value of the note insurance is provided by
the equity holders (as represented by the light gray shaded box in the left
hand part of Figure 6.8). As can be seen immediately, the amount of invested
equity capital and the amount of economic capital can differ. Note that most
of the economic capital is provided by the shareholders, but contrary to the
RAROC world, not necessarily all of it.
The left-hand part of Figure 6.8 depicts the accounting balance sheet
view of the transaction. The book value of the asset BV A
equals the sum of
the book value of debt BV D
and the book value of the equity BV E
; however,
BV D
, and BV E
net of the contribution to the economic capital pool do not
represent the economic value of debt and equity, nor is economic capital
considered as an asset.
This is done in the economic balance sheet view—as depicted in the
right-hand part of Figure 6.8. Note that the amount of required economic
capital is unchanged in this world because it was already determined on an
economic basis beforehand. And again, the market value of debt (V D,t
) and
equity (V E,t
) add up to the market value of the transaction (V A,t
). 104 Again,
V E,t
can be very different from EC. Especially the amount of invested capital
(i.e., V E,0
at time t = 0) at the initiation of transaction A, does not have to
equal EC. This also makes explicit the fact that economic capital cannot be
required to make the equity hurdle rate—only the cash capital has to.
However, this raises the question: What is the adequate return that economic
capital has to earn in order to create value for the bank? We will address this
question in the next section.
Before we do so, we can briefly summarize the previous points:
■
Setting economic capital equal to equity (provided by the shareholders)
ignores the default risk (of other tranches) and is, therefore, only
a first-order approximation 105 of reality.
103 Recall from above that the value of a risky bond is the sum of a risk-free bond
plus the value of the put option.
104 However, this is not an indicator that capital structure is irrelevant.
105 See Crouhy et al. (1999), p. 21, footnote 21.