Risk adjusted pricing (De Laurentis)

[saurabhpal49]

Hi David,
Could you please explain the risk adjusted pricing concept from delaurentis reading

I am not able to understand the basic idea of this reading

Could you also please explain each of the 3 formulas and their constituents

Raroc> Roe

Eva= (Raroc-ke)* Economic capital

Raroc =spread+fees-El-Coc-Coc/ Economic capital

 

[David Harper CFA FRM]

Hi @saurabhpal49 Your questions are good. The challenge is that (i) these are huge topics and, unfortunately, (ii) the De Laurentis reading is weak. My feedback to GARP is that the De Laurentis reading is among the weakest readings in the current syllabus. It contains numerous errors, and does not define key terms. Here in 2.2.3 he is writing (trying to write) an extremely quick summary of deep topics. And, as I've told GARP, a key problem is that he tends to give no illustrative calculations (which normally provide two services: they convey the concept concretely; and they enforce robustness. The lack of illustrative calculations in this chapter masks certain errors). So, I wouldn't expect you to understand the basic idea of this reading as a standalone I don't have current time to write freshly on each of these, but let me try to point you in the right direction:

Risk-adjusted pricing: Others may have a better definition, but I view this as pricing (normally as reflected in the interest rate or yield charged to customers for loans extended on the asset side of the balance sheet) that is adjusted for all risks, not only default risks but risks to capital (on the balance sheet side that funds the assets). If you think about the commercial bank as selling a product (loans) to customers for a price (interest rate), then this is the idea of fully-loading such the price charged to customers for all risks incurred. Of course a loan's interest rate is already higher than the risk-free rate, to compensate for the expected losses due to default (credit risk). That's a given. But risk-adjusted pricing implies further that the pricing is also aware of the cost of unexpected losses, which are costly to the bank because it needs to employ capital in contingent anticipation of unexpected losses (specifically: economic capital, regulatory capital, and equity capital).

For RAROC, I would point you instead to Crouhy's Chapter 17 (https://learn.bionicturtle.com/topic/study-notes-crouhy-chapter-15-17/). Crouhy gives an RAROC, which I replicated (for our note) in this simple XLS http://trtl.bz/crouhy-raroc
... our study note goes into quite a bit of detail on this RAROC ratio (illustrated below)
... De Laurentis refers to this as RARORAC but he's not precise so who knows what he means. RARORAC implies both the numerator and denominator of the general form return on capital (ROC) are "risk-adjusted" so RARORAC actually implies VaR in the denominator.

For EVA, that's a whole big topic. I have consulted to many companies on EVA, so I wrote a tutorial for investopedia on EVA at investopedia http://www.investopedia.com/university/eva/

I hope that's a helpful start. If you have specific further questions, I'll be glad to try and help. Thanks!

 

[David Harper CFA FRM]

@saurabhpal49 I forgot to share the attached presentation to GARP on RAROC by Dr. Yousef Padganeh (Head of Enterprise Risk Management, Commercial Bank International). I think he gives some useful illustrations and he has a slide on risk-based pricing. I hope that's helpful!

 

[Merlinius]

The "cost of capital" in the RAROC numerator does not include the "cost of shareholders' capital" which is part of the EVA definition, correct?