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

266 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
Table 6.3
CAPM Hurdle Rate and Economic Capital
Systematic Specific Systematic Specific
Risk Risk Risk Risk
Types of Risk (%) (%) (in Dollars) (in Dollars)
Credit Risk 70% 30% 35 15
Market Risk 95% 5% 19 1
Operational Risk 10% 90% 3 27
57 43
Total Economic
Capital 100
We now assume that—as suggested in the RAROC methodology—the
required economic capital amount 110 has to earn the required CAPM return.
If the risk-free rate (R f
) equaled 6%, the market risk premium (R M
–
R f
) was also 6%, and the bank’s CAPM beta (β) was 1.0, the hurdle rate
could be determined via the following equation:
Hurdle Rate = R f
+ β ⋅ (R M
– R f
) (6.15)
= 6% + 1 ⋅ 6% = 12%.
Therefore, the required return on a dollar amount would be 12% ⋅ 100
= 12. However, we know that the market (in the CAPM sense) does not
price specific risk, that is, it is only compensated at the risk-free rate. Holding
economic capital for specific risk (which is necessary in our above definition)
therefore should only be compensated at 6% and not 12%. Hence,
the adjusted required return is: 57 ⋅ 12% + 43 ⋅ 6% = 9.42, which is 21.5%
less than what the RAROC model would require.
This example reveals two serious problems with RAROC when it is used
to determine the value created by a transaction:
■
■
The CAPM-based hurdle rate only considers systematic risk, whereas
economic capital is a total risk measure.
Economic capital is measured as the total risk contribution to the
(existing) bank portfolio (internal beta). It does not (necessarily) reflect
the correlation to a broad market portfolio as required by the CAPM
(external beta).
110 To make matters even more plausible, we could additionally assume that (coincidentally)
economic capital is equal to shareholder capital.