Risk-Adjusted Measures Of Value Creation In Financial Institutions
Source: Bank of Finland
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.