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

A trading desk earns risk-adjusted profit of $30 million on $250 million of allocated economic capital. The bank's hurdle rate is 10%. A manager proposes reducing the hurdle rate used for this desk to 8% because the desk's revenues are 'stable'. Which statement best describes the effect and the correct practitioner view?

EVA would rise from $5 million to $10 million, but that is an artifact. The hurdle rate should reflect the activity's systematic risk, while stability of revenues is already captured in the economic capital allocation, so discretionary lowering is not justified.

  1. AEVA would rise from $5 million to $10 million, but the hurdle should reflect the systematic risk of the activity and not the manager's perception of revenue stabilityCorrect
  2. BEVA would rise from $5 million to $10 million, and the change is appropriate because stable revenues imply lower risk capital
  3. CEVA would fall from $5 million to $0 because a lower hurdle rate reduces the capital base
  4. DEVA would be unchanged because the hurdle rate only affects RAROC and not EVA

Explanation

At 10%, charge = $25m so EVA = $5m. At 8%, charge = $20m so EVA = $10m. The hurdle rate should reflect the systematic (non-diversifiable) risk of the activity, since idiosyncratic or total volatility is already captured in economic capital. Lowering it by discretion inflates EVA without any real change in value creation.

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