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FRM Part I · FRM Exam Part I · Enterprise Risk Management and Future Trends

A firm compares two projects using RAROC. Project X earns expected profit of USD 18 million after expected losses and requires economic capital of USD 120 million. Project Y earns USD 14 million after expected losses and requires USD 70 million. The hurdle rate is 18%. Which conclusion is correct?

RAROC is risk-adjusted profit divided by economic capital. Project X gives 18/120 = 15%, below the 18% hurdle, while Project Y gives 14/70 = 20%, above it. Only Y qualifies; comparing absolute profits ignores the capital each project consumes.

  1. AOnly X meets the hurdle because its absolute profit is higher
  2. BBoth meet the hurdle
  3. CNeither meets the hurdle
  4. DOnly Y meets the hurdle because its RAROC is 20% versus 15% for XCorrect

Explanation

RAROC X = 18/120 = 15%, below 18%. RAROC Y = 14/70 = 20%, above 18%. Absolute profit ignores the capital consumed, which is the error in the first option.

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