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

A risk manager notes that a trading desk's RAROC is high mainly because its economic capital is computed from a 99% one-day VaR scaled by the square root of ten, using a calm historical window. Which concern about using this RAROC for capital allocation is most valid?

The main concern is that a calm-period VaR understates economic capital, shrinking the denominator and inflating RAROC. This can make the desk look more attractive than it is and encourage excessive risk-taking and over-allocation of capital.

  1. ARAROC cannot be calculated for trading desks
  2. BUnderstated capital in the denominator inflates RAROC, encouraging excess risk-takingCorrect
  3. CExpected losses are double-counted in the numerator
  4. DThe hurdle rate must equal the risk-free rate

Explanation

RAROC is only as reliable as the capital measure. A calm-period VaR understates tail risk, shrinking the denominator and inflating RAROC. The other options misstate how RAROC works.

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