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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank evaluates two loan portfolios using RAROC. Portfolio X: risk-adjusted return $9 million, economic capital $60 million. Portfolio Y: risk-adjusted return $12 million, economic capital $100 million. The bank's cost of equity is 13%. Which statement is correct?

Portfolio X has RAROC of 15% and exceeds the 13% cost of equity, so it creates value; Portfolio Y has 12% and falls short, so it destroys value. Y's larger dollar return is misleading because it uses much more capital.

  1. AX has RAROC 15% and creates value; Y has RAROC 12% and destroys valueCorrect
  2. BX has RAROC 12% and destroys value; Y has RAROC 15% and creates value
  3. CBoth create value because returns are positive
  4. DBoth destroy value because RAROC is below 20%

Explanation

X: 9/60 = 15% > 13%, creating value. Y: 12/100 = 12% < 13%, destroying value. Y has higher absolute return but lower RAROC, so absolute profit is misleading.

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