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

A bank uses a single bank-wide hurdle rate of 12% to judge RAROC for all units. The trading unit has a RAROC of 14% and the retail mortgage unit has 11%. The trading unit's returns are far more volatile and cyclical, with systematic risk well above the retail unit. What is the main implementation problem with this practice?

A single hurdle rate ignores differences in systematic risk across units. The volatile, cyclical trading unit probably has a higher required return than 12%, so its 14% RAROC may overstate value creation, while the low-beta mortgage unit may be unfairly penalized.

  1. ARAROC cannot be computed for trading units
  2. BA uniform hurdle ignores differences in systematic risk, so it can favor high-beta units that look value-creating but may not earn their true cost of equityCorrect
  3. CThe hurdle rate should always be set below the risk-free rate
  4. DMortgage units should never be assessed with RAROC

Explanation

Economic capital reflects total (diversifiable plus systematic) risk, whereas shareholders price only systematic risk. Using one hurdle can lead to over-investing in high-beta units and under-investing in low-beta ones. The hurdle should be adjusted for each unit's beta.

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