Risk-adjusted measures of value creation in financial institutions
AbstractMeasuring value creation by comparing the RAROC of an exposure (the return on risk capital) with a single institution-wide hurdle rate is inconsistent with the standard theory of financial valuation. We use asset pricing theory to determine the appropriate hurdle rate for such a RAROC performance measure. We find that this hurdle rate varies with the skewness of asset returns. Thus the RAROC hurdle rate should differ substantially between equity which has a right skew and debt which has a pronounced left skew and also between different qualities of debt exposure. We discuss implications for financial institution risk management and supervision.
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Bibliographic InfoPaper provided by Bank of Finland in its series Research Discussion Papers with number 25/2009.
Length: 37 pages
Date of creation: 02 Nov 2009
Date of revision:
asset pricing; banking; capital allocation; capital budgeting; capital management; corporate finance; downside risk; economic capital; performance measurement; RAROC; risk management; value creation; hurdle rate; value at risk;
Find related papers by JEL classification:
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-12-11 (All new papers)
- NEP-BAN-2009-12-11 (Banking)
- NEP-BEC-2009-12-11 (Business Economics)
- NEP-CFN-2009-12-11 (Corporate Finance)
- NEP-RMG-2009-12-11 (Risk Management)
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- Alistair Milne, 2010. "Macro-Prudential Policy: An Assessment," CESifo DICE Report, Ifo Institute for Economic Research at the University of Munich, vol. 8(1), pages 28-33, 04.
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