Explanation:
In the RAROC framework, the sum of the interest rate spread and loan origination fees forms the revenue part of the equation, from which the combined total of expected loan losses and operating costs are subtracted. In this scenario, Loan X has a higher combined total of expected losses and operating costs (€35,000) compared to Loan Y (€30,000). This means that even though both loans generate the same revenue from spreads and fees, Loan Y will have a higher RAROC value because its lower total deductions (expected losses plus operating costs) result in a higher net revenue figure. Therefore, Loan Y is more profitable in terms of RAROC, as it retains more revenue after accounting for losses and costs.
Things to Remember
Ultimate access to all questions.
No comments yet.
Q.6016 A bank is assessing two different loans using the Risk-Adjusted Return on Capital (RAROC) model. Both loans have identical principal amounts, interest rate spreads, and origination fees. However, Loan X has expected loan losses of €30,000 and operating costs of €5,000, while Loan Y has expected loan losses of €20,000 and operating costs of €10,000. All other factors constant, how do the differences in expected loan losses and operating costs between Loan X and Loan Y affect their respective RAROC values?
A
Loan X will have a higher RAROC as lower operating costs outweigh higher expected loan losses.
B
Loan Y will have a higher RAROC as lower expected loan losses outweigh higher operating costs.
C
Both loans will have the same RAROC as the differences in expected losses and operating costs cancel each other out.
D
It is impossible to determine which loan will have a higher RAROC without knowing the interest rate spreads and origination fees.