Explanation:
RAROC is calculated as:
RAROC = (Revenue - Expected Loss - Operating Expenses - Funding Cost + Return on Economic Capital) / Economic Capital
Given current RAROC = 21.1%
Let's calculate the impact of each option:
Current values:
Option A: Operating expenses decrease by 50%
Option B: Revenue increases by 20%
Option C: Return on EC increases to 4%
Option D: Funding cost decreases to 0.5%
Comparison:
Option B provides the largest RAROC increase at 6.81%. The revenue increase has the most significant impact on the numerator while the denominator (economic capital) remains unchanged.
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A risk manager is considering a HKD 400 million loan that will be fully funded by deposits paying an average annual interest rate of 1.0%. The risk manager has estimated the following regarding the loan:
| Expected annual revenue: | HKD 16 million |
|---|---|
| Expected loss: | HKD 1.0 million |
| Unexpected loss: | HKD 48.0 million |
| Economic capital required: | HKD 47.0 million |
| Annual operating expenses: | HKD 2.0 million |
Assuming the economic capital can be invested so that it earns 2% per year, the risk manager correctly calculates the risk-adjusted return on capital (RAROC) to be 21.1%. Assuming nothing else changes, which of the following would increase the RAROC estimate the most?
A
Annual operating expenses decrease by 50%.
B
Expected annual revenue increases by 20%.
C
The economic capital can be invested so that it earns 4% per year.
D
The loan is fully funded by deposits paying an average annual interest rate of 0.5%.