Risk Capital Attribution and Risk-Adjusted Performance Measurement (FRM Part 2 – Book 3 – Ch 12)

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After completing this reading, you should be able to:
- Define, compare and contrast risk capital, economic capital and regulatory capital, and explain methods and motivations for using economic capital approaches to allocate risk capital.
- Describe the RAROC (risk-adjusted return on capital) methodology and its use in capital budgeting.
- Compute and interpret the RAROC for a project, loan, or loan portfolio and use RAROC to compare business unit performance.
- Explain challenges that arise when using RAROC for performance measurement, including choosing a time horizon, measuring default probability and choosing a confidence level.
- Calculate the hurdle rate and apply this rate in making business decisions using RAROC.
- Compute the adjusted RAROC for a project to determine its viability.
- Explain challenges in modeling diversification benefits, including aggregating a firm’s risk capital and allocating economic capital to different business lines.
- Explain best practices in implementing an approach that uses RAROC to allocate economic capital