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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 RAROC of 18% against a 12% hurdle, using capital allocated at the 99.9% confidence level based on a three-year loss history that contained no crisis. The risk team argues the desk's capital is understated. Which implementation issue most directly undermines the RAROC comparison?

The key problem is that capital is estimated from a short, benign three-year window that contains no crisis, so the tail loss and allocated capital are understated. Since capital is RAROC's denominator, the ratio is overstated, making the desk appear to clear its hurdle when it may not.

  1. ACapital is estimated from a short, benign data window, so the denominator is understated and RAROC is overstatedCorrect
  2. BThe hurdle rate is set below the cost of equity, which lowers the numerator
  3. CRAROC cannot be computed for trading desks, only for lending units
  4. DThe confidence level is too high, which inflates the capital figure

Explanation

RAROC equals risk-adjusted return divided by allocated capital. A short window without stress produces a tail estimate that is too low, so the denominator is understated and RAROC inflated, especially at 99.9% where few observations inform the tail. Option D reverses the effect: a high confidence level raises capital, but the data limit offsets it.

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