Risk-Adjusted Return on Capital Models

RAROC Models

• An increasingly popular model used to evaluate credit risk based on

market data is the RAROC model.

• The RAROC (risk-adjusted return on capital) was founded by

Bankers Trust (acquired by Deutsche Bank in 1998) and has now been

adopted by virtually all the large banks in the United States and

Europe, although with some significant differences between them.

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The essential idea behind RAROC is that rather than evaluating the actual or

contractually promised annual ROA on a loan, (that is, net interest and fees

divided by the amount lent), the lending officer balances expected interest

and fee income less the cost of funds against the loan’s expected risk. Thus,

the numerator of the RAROC equation is net income (accounting for the cost

of funding the loan) on the loan.

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• Further, rather than dividing annual loan income by
assets lent, it is divided by some measure of asset (loan)
risk or what is often called capital at risk, since
(unexpected) loan losses have to be written off against an
FI’s capital
RAROC = One year net income on a loan
Loan (asset) risk or capital at risk

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• A loan is approved only if RAROC is sufficiently high
relative to a benchmark return on capital (ROE) for the FI,
where ROE measures the return stockholders require on
their equity investment in the FI.
• The idea here is that a loan should be made only if the risk-
adjusted return on the loan adds to the FI’s equity value as
measured by the ROE required by the FI’s stockholders.

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• Thus, for example, if an FI’s ROE is 15 percent, a loan should be made only if

the estimated RAROC is higher than the 15 percent required by the FI’s

stockholders as a reward for their investment in the FI.

• Alternatively, if the RAROC on an existing loan falls below an FI’s RAROC

benchmark, the lending officer should seek to adjust the loan’s terms to make it

“profitable” again. Therefore, RAROC serves as both a credit risk measure and a

loan pricing tool for the FI manager.

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 Definition of RAROC
AdjustedIncome
• RAROC = CapitalatRisk

• If RAROC > Hurdle rate then value adding.

• ROA = AdjustedIn come
AssetsLent

• RORAC = AdjustedIncome
Risk  basedCapital Re quirement

• EVA = economic value added = Adjusted

income – ROE x K. Invest if  0.
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 The Numerator: Adjusted Income

• = Spread (direct income on loan)

• + Fees (directly attributable to loan)

• - Expected Loss (EDF x LGD)

• - Operating Costs (allocated to loan)

• Then multiply the entire amount by 1 – the marginal tax

rate.

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 The Denominator: Capital at Risk

• Market-based approach (BT model)

Measure the maximum adverse change in the market value of the loan
resulting from an increase in the credit spread

Use duration model to measure price effects.

• Experientially-based approach (BA model)

Calculate UL using a multiple x LGD x exposure x standard deviation of
default rates.

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 The Market-based Approach to
Measuring Capital at Risk
L = -DL x L x R/(1+RL) (13.9)

(Dollar capital risk (Duration (Risk amount or (Expected discounted change in

the
exposure or loss of the loan loan exposure) credit premuim or risk factor
on the
amount) loan)

• If DL=2.7, L=$1m, R=1.1%, R=10%, then:

L = -$ 27,000
• (1.1/100=0.011), =0.011/1.10=0.01
• -2.7x1,000,000x0.01= -27000
Saunders & Allen Chapter 13 10
 The Experientially-based Approach to Capital at Risk
Measurement

• If 99.97% VAR (AA rating) and normal distribution, then the

multiplier is 3.4.
• But, most banks use a large multiplier because loan
distributions are not normal.
• BA uses multiplier = 6.

• If LGD=.5, Exposure=$1m, Loan =.00225, then UL=6 x .

00225 x .5 x $1m = $27,000 (same as market-based approach)

Saunders & Allen Chapter 13 11

 Calculating the RAROC of the
Loan Example
• Spread = .2% x $1m = $2,000
• Fees = .15% x $1m = $1,500
• EL = .1% x $.5m = ($500)
• Tax rate = 0%
• Adjusted Income = $3,000
• RAROC = $3,000/$27,000 = 11.1%
• If cost of capital < 11.1% then make loan.
Saunders & Allen Chapter 13 12
 Incorporating Unsystematic Risk

• Banks specialize in relationship lending that cannot be hedged in capital markets.

Risk of loan should be divided into:

(1) liquid, hedgeable market risk component

(2) illiquid, unhedgeable component.

• The correlation of the unhedgeable component with the bank’s portfolio will
determine the loan’s price. So different banks (with different portfolio
correlations) will have different pricing (credit risk).
• Froot & Stein (1998): Loan’s hurdle rate =market price of the loan’s traded risk
+ bank shareholders’ cost of capital to cover non tradable risk. The second term
is idiosyncratic.

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 Liquidity risk
• Liquidity risk is a financial risk that for a certain period of time
given financial assets, security or commodity cannot be traded quickly
enough in the market without impacting the market price.

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 Types of liquidity risk
•Market liquidity: An asset cannot be sold due to lack of liquidity in the
market , essentially a sub-set of market risk. This can be accounted for by:
• bid/offer spread

•Making explicit liquidity reserves

•Lengthening holding period for VaR calculations

•Funding liquidity

Risk that liabilities:

•Cannot be met when they fall due

•Can only be met at an uneconomic price

•Can be name-specific or systemic

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 Causes

Liquidity risk arises from situations in which a party

interested in trading an asset cannot do it because nobody in
the market wants to trade for that asset. Liquidity risk
becomes particularly important to parties who are about to
hold or currently hold an asset, since it affects their ability to
trade.

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• Depository institutions are the FIs most exposed to liquidity risk.
Mutual funds, pension funds, and insurance companies are the least
exposed. In the middle are life insurance companies.

Reasons
• Liquidity risk occurs because of situations that develop from economic
and financial transactions that are reflected on either the asset side of
the balance sheet or the liability side of the balance sheet of an FI.
Asset-side risk arises from transaction that result in a transfer of cash
to some other asset, such as the exercise of a loan commitment or a
line of credit

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 SPOT Market and Forward Market

• Difference between SPOT Market and Forward Market

Foreign exchange markets are sometimes classified into spot market and
forward market on the basis of the period of transaction carried out. It is
explained below:
(a) Spot Market:
If the operation is of daily nature, it is called spot market or current market.
It handles only spot transactions or current transactions in foreign

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• Transactions are affected at prevailing rate of Exchange at that point of time and
delivery of foreign exchange is affected instantly. The exchange rate that prevails in
the spot market for foreign exchange is called Spot Rate. Expressed alternatively, spot
rate of exchange refers to the rate at which foreign currency is available on the spot.
• For instance, if one US dollar can be purchased for Rs 40 at the point of time in the
foreign Exchange market, it will be called spot rate of foreign exchange. No doubt,
spot rate of foreign exchange is very useful for current transactions but it is also
necessary to find what the spot rate is. 
• In addition, it is also significant to find the strength of the domestic currency with
respect to all of home country’s trading partners. Note that the measure of average
relative strength of a given currency is called Effective Exchange Rate (EER)

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b) Forward Market:
A market in which foreign Exchange is bought and sold for future delivery is
known as Forward Market. It deals with transactions (sale and purchase of
foreign exchange) which are contracted today but implemented sometimes in
future.
A forward contract is entered into for two reasons:

(i) To minimize risk of loss due to adverse change in Exchange rate (i.e.,
Hedging)

[ii] to make a profit (i.e., speculation).

• Two Exchange rate quotes: In foreign exchange market, there are two

exchange rate quotes, namely, buying rate and selling rate. If a person

goes to the exchange market to buy foreign currency, say, US dollars,

he has to pay higher rate than when he goes to sell dollars. In other

words, for a person buying rate is higher than selling rate.

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• An ‘Option’ is a type of security that can be bought or sold
at a specified price within a specified period of time, in
Exchange for a non-refundable upfront deposit. An options
contract offers the buyer the right to buy, not the
obligation to buy at the specified price or date. Options are
a type of derivative product.

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• The right to sell a security is called a ‘Put Option’, while the right to
buy is called the ‘Call Option’.
They can be used as:
• Leverage: Options help you profit from changes in share prices
without putting down the full price of the share. You get control over
the shares without buying them outright.
• HEDGING: They can also be used to protect yourself from
fluctuations in the price of a share and letting you buy or sell the
shares at a pre-determined price for a specified period of time.

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• Though they have their advantages, trading
in options is more complex than trading in
regular shares. It calls for a good
understanding of trading and investment
practices as well as constant monitoring of
market fluctuations to protect against
losses.

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• Premium: The upfront payment made by the buyer to the
seller to enjoy the privileges of an option contract.
• Strike Price / Exercise Price: The pre-decided price at which
the asset can be bought or sold.
• Strike Price Intervals: These are the different strike prices at
which an options contract can be traded. These are determined
by the Exchange on which the assets are traded.

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• CALL OPTION
The ‘Call Option’ gives the holder of the option the right to buy
a particular asset at the strike price on or before the expiration
date in return for a premium paid upfront to the seller. Call
options usually become more valuable as the value of the
underlying asset increases. Call options are abbreviated as ‘C’ in
online quotes.

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• PUT OPTION:

The Put Option gives the holder the right to sell a particular asset at the strike
price anytime on or before the expiration date in return for a premium paid up
front. Since you can sell a stock at any given point of time, if the spot price of a
stock falls during the contract period, the holder is protected from this fall in
price by the strike price that is pre-set. This explains why put options become
more valuable when the price of the underlying stock falls.

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