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

A bank's trading desk shows a high stand-alone return on capital, but its returns are highly correlated with the rest of the bank's portfolio, while a retail unit with a lower stand-alone return is largely uncorrelated with the bank. Which conclusion about attributing capital is most appropriate?

Marginal-contribution capital gives the correlated trading desk little diversification credit, so its allocated capital stays high relative to stand-alone and its risk-adjusted return falls. The uncorrelated retail unit gets more diversification credit, which improves its return on allocated capital.

  1. AStand-alone capital should be used because it is the only method independent of other units
  2. BMarginal-contribution capital is likely to be higher for the trading desk relative to its stand-alone capital than for the retail unit, lowering its risk-adjusted returnCorrect
  3. CBoth units should receive identical capital because diversification benefits belong to the whole bank
  4. DCorrelation should be ignored because it changes over time

Explanation

Under marginal or Euler attribution, a unit highly correlated with the bank receives little diversification credit, so its allocated capital is close to its stand-alone figure and its RAROC falls. The uncorrelated retail unit receives a larger diversification credit, improving its return on allocated capital.

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