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Risk-adjusted measures of value creation in financial institutions

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Author Info

  • Milne, Alistair

    ()
    (Faculty of Finance, Cass Business School, City University, London and Bank of Finland Research)

  • Onorato, Mario

    ()
    (Algorithmics Inc & Faculty of Finance, Cass Business School, City University, London)

Abstract

Measuring 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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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0925netti.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 25/2009.

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Length: 37 pages
Date of creation: 02 Nov 2009
Date of revision:
Handle: RePEc:hhs:bofrdp:2009_025

Contact details of provider:
Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Related research

Keywords: 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;

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Cited by:
  1. 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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