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

A bank's board wants to use EVA to reward business heads. Which design concern is most important when linking EVA-based bonuses to shareholder value?

The key concern is that single-period EVA can reward excessive risk taking if the capital charge is not risk-sensitive. Using economic capital for the charge and assessing performance over several years aligns manager incentives with long-term shareholder value.

  1. AA single-year EVA can encourage excessive risk taking unless capital charges reflect risk and results are assessed over a multi-year horizonCorrect
  2. BEVA ignores the cost of capital, so it overstates value
  3. CEVA is unaffected by the economic capital allocated, so risk cannot be gamed
  4. DEVA should use book equity only, since economic capital adds subjectivity and distorts incentives

Explanation

EVA deducts a capital charge, so it does include cost of capital. If the charge is not risk-based or the horizon is one year, managers may take tail risks that boost current EVA. Multi-year assessment and risk-sensitive capital allocation mitigate this.

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