RAROC calculation fomr Crouhy

[shanlane]

Hello,

I just noticed something a little strange with the RAROC calculation in the Crouhy reading. On p 533, he says that we are considering a loan portfolio worth $1B. However when he calculates the interest expense, it is only on $925 million, because the economic capital is $75 million. If we have to borrow the full $1B, then why is the interest expense not on the entire amount? The interest revenue is based on $1B. Is it assumed that we must already have the $75 million and therefore are only borrowing $925 million? If so, is that a normal expectation (one that we should be prepared to make on the test)? It just seems like something is a little off.

Thanks!

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

In this case, if you might look in the forum or conduct a search, you'll find literally dozens of threads on this discrepancy (Crouhy's first version uses $925, but I actually years ago submitted to them why $1 BB would make more sense, and the 2nd print funds the assets with a MATCHING $1 billion in liabilities). I've submitted this to GARP, but I don't think they've really noticed. An exam question will surely specify the deposits.

In the meantime, the consensus view reach here (to which i agree) , in my summary of the discussions, is that $1 billion deposits = $1 billion is a better assumption. But "RAROC" search will produce threads etc (including that i mistakenly retained the 925-type approach in the notes, which i do mean to correct).

The learning XLS shows it both ways where neither is "incorrect" because both have a balanced balance sheet; I think it's fair to say the XLS shows that either is possible/balances the balance sheet.

Thanks.

 

[shanlane]

Thanks!

Shannon