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Answer: RAROC will make it easier to compare the profitability of business divisions that require different levels of capital.
## Explanation **A is correct.** RAROC (Risk-Adjusted Return on Capital) allows firms to compare the profitability of business lines that require different amounts of economic capital. This is one of the key advantages of RAROC as it normalizes returns by the amount of capital required, enabling fair comparisons across different business units. **B is incorrect.** RAROC does not provide a benchmark against a peer group; rather it assesses if internal projects or business units are providing value to the firm (i.e., providing risk-adjusted returns higher than the firm's cost of equity capital). **C is incorrect.** RAROC uses an expected return but does not quantify losses during stress scenarios; other metrics such as expected loss or methods such as scenario analysis are more useful in assessing potential extreme losses during stress situations. **D is incorrect.** The activity is adding value if its RAROC is **higher** than the cost of equity capital, not the other way around. When RAROC exceeds the cost of capital, it indicates the activity is creating shareholder value.
Author: LeetQuiz .
A junior analyst at a bank is asked to provide suggestions on potential metrics the bank can use in its capital management program. The analyst prepares a presentation discussing the advantages and disadvantages of the RAROC metric. Which of the following statements is most appropriate for the analyst to include in the presentation?
A
RAROC will make it easier to compare the profitability of business divisions that require different levels of capital.
B
RAROC allows the firm to benchmark its performance against operating targets set by industry peers.
C
RAROC is an effective forward-looking tool to model potential extreme losses during stress scenarios.
D
An activity is adding value to the bank's shareholders if its cost of equity capital is higher than its RAROC.
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