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

A bank uses stand-alone capital for performance measurement. Its trading desk is weakly correlated with the lending book. What is the most likely consequence of evaluating the trading desk on stand-alone capital rather than diversified contribution?

The desk's risk-adjusted return is understated. Stand-alone capital ignores the diversification benefit a weakly correlated desk gives the firm, so the capital denominator is too high and measures like RAROC come out lower than its true contribution warrants.

  1. AThe desk's risk-adjusted return is overstated because capital is understated
  2. BThe desk's risk-adjusted return is understated because its diversification benefit is ignoredCorrect
  3. CThe desk's capital will sum exactly to firm capital
  4. DThe desk's capital will be lower than its marginal capital

Explanation

Stand-alone capital ignores the diversification the desk provides to the firm, so it is higher than its diversified contribution. A larger denominator lowers RAROC, understating the desk's risk-adjusted return. Stand-alone amounts also sum to more than firm capital.

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