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Measuring value creation by comparing the RAROC of an exposure (the return on risk capital) with a single institution-wide hurdle rate is inconsistent with the standard theory of financial valuation. The authors use asset pricing theory to determine the appropriate hurdle rate for such a RAROC performance measure. They find that this hurdle rate varies with the skewness of asset returns. Thus the RAROC hurdle rate should differ substantially between equity which has a right skew and debt which has a pronounced left skew and also between different qualities of debt exposure. They discuss implications for financial institution risk management and supervision.
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