Risk-adjusted measures of value creation in financial institutions
journal contributionposted on 09.07.2014 by Alistair Milne, Mario Onorato
Any type of content formally published in an academic journal, usually following a peer-review process.
Many financial institutions assess portfolio decisions using RAROC, the ratio of expected return to risk (or ‘economic’) capital. We use asset pricing theory to determine the appropriate hurdle rate, finding that this varies with the skewness of asset returns. We quantify this discrepancy under a range of assumptions showing that the RAROC hurdle rate differs substantially, being higher by a factor of five or more for equity which has a right skew compared to debt which has a pronounced left skew, and also between different qualities of debt exposure. We discuss implications for both financial institution risk management and supervision.
- Business and Economics