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

A firm has two business units. Unit A earns an expected profit of USD 18 million and is allocated economic capital of USD 120 million. Unit B earns an expected profit of USD 30 million and is allocated economic capital of USD 250 million. The firm's hurdle rate is 14%. Which statement is correct when units are judged on RAROC against the hurdle rate?

Unit A has a RAROC of 15% (18/120), above the 14% hurdle, while Unit B has 12% (30/250), below it. So only Unit A exceeds the hurdle. Absolute profit is misleading because Unit B uses much more economic capital.

  1. AUnit A exceeds the hurdle rate and Unit B does notCorrect
  2. BBoth units exceed the hurdle rate
  3. CUnit B exceeds the hurdle rate and Unit A does not
  4. DNeither unit exceeds the hurdle rate

Explanation

RAROC for A = 18/120 = 15%, above 14%. RAROC for B = 30/250 = 12%, below 14%. Judging on absolute profit would wrongly favor B, which has the larger profit but a lower return per unit of capital.

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