Measuring risk-adjusted performance

Michel Crouhy and Stuart M. Turnbull

Market Risk Management, Canadian Imperial Bank of Commerce, 161 Bay Street,
Level 11, Toronto, Ontario, Canada M5J 2S8
Lee M. Wakeman
Risk Analysis & Control, 2 Weed's Landing, Darien, Connecticut 06820, USA
Many banks follow the dictum of maximizing the risk-adjusted return on economic
capital, subject to constraints imposed by regulatory requirements. The authors show
that commonly employed methods may result in decisions that adversely affect
shareholder value. They present an alternative methodology, adjusted RAROC, that
corrects the inherent limitations of the existing methods.
1. INTRODUCTION
Many large US and foreign banks have introduced performance evaluation
methods designed to allocate capital among their dierent businesses. Tradi-
tional performance measures such as return on capital have long been
recognized as failing to take into account the risk of the underlying business
and the value of future cash ows. The capital asset pricing model (CAPM)
provides a framework for determining the net present value of a business.
Expected future cash ows are discounted using a risk-adjusted expected rate of
return. Risk is dened in terms of the covariance of changes in the market value
of the business with changes in the value of the market portfolio. This form of
risk measure is usually referred to as the beta coecient. For an introduction to
the CAPM and discussion of the beta coecient, see Brealey and Myers (2000).
For a portfolio of assets, risk in the CAPM is dened in terms of the standard
deviation of the portfolio's return. The Sharpe ratio is a measure of the relative
attractiveness of dierent portfolios. It maps the expected return and the risk
into a single measure. It is argued that the larger the Sharpe ratio, the better the
portfolio, and hence the objective of portfolio manager's is to maximize the
Sharpe ratio or, equivalently, the expected return on risk-adjusted capital.
For many businesses, measuring the rm's beta and the beta of an invest-
ment presents a formidable challenge given the absence of market data.
Practitioners have also expressed the concern that measures of risk such as
beta, do not consider the risk and costs associated with default. Consequently,
other forms of expected return/risk measures have been introduced (see Froot
and Stein 1996).
The stated objective of these risk-based capital allocation systems, which are
often grouped together under the acronym RAPM (risk-adjusted performance
5
measurement), is to provide a uniform measure of performance that manage-
ment can use to compare the economic protability of businesses with dierent
sources of risk and dierent capital requirements.
A generic RAPM takes the form
RAPM
Expected Revenues Costs Expected Losses
Economic Capital
. (1)
where `Expected Revenues' is the expected revenues assuming no losses,
`Expected Losses' is the expected losses from default, and `Economic Capital'
is usually dened as the capital necessary to cushion against unexpected losses,
operating risks, and market risks, and is often referred to as value-at-risk (see
Ong 1999, p. 218). The magnitude of the economic capital is usually determined
so that the probability of unexpected losses is below some specied level. Matten
(1996, p. 59) describes four dierent risk-adjusted performance measurement
models, the two commonly used models being RAROC (risk-adjusted return on
capital) and RORAC (return on risk-adjusted capital).
1
The RAROC approach
adjusts the numerator of expression (1) to take account of various risks, and the
RORAC approach adjusts the denominator to the account for the same risks.
Matten correctly observes that there is considerable confusion between the two
approaches. In this paper we will simply use the term RAROC.
Bankers Trust developed the RAROC methodology in the late 1970s.
According to Zaik et al. (1996), their original intent was to measure the risk
of the bank's credit portfolio and the amount of equity capital necessary to limit
the bank to a specied probability of loss. The method of measuring the risk
and the time horizon are issues that require specication. The denition of risk
has moved away from a market-driven denition of risk to a measure of risk that
is purely rm specic. It is implicitly assumed that RAROC correctly compen-
sates for changes in risk. Consequently, it is assumed that it can be used to
measure the performance of dierent types of businesses and that decisions
based on RAROC are consistent with maximizing the wealth of existing
shareholders.
Zaik et al. (1996) state that Bank of America's policy is to capitalize each of
its business units in a manner consistent with the bank's desired credit rating on
the unit's stand-alone risk. If a business unit's RAROC is higher than the cost of
the bank's equitythe minimum rate of return required by shareholdersthen
the unit is deemed to be adding value to shareholders. This assumes that the risk
of the economic capital of the stand-alone business is the same as that of the
bank's equity (see footnote 8 for further discussion).
1
RAROC makes a risk adjustment to the numerator by subtracting a risk factor from the return:
RAROC = (Return Risk Adjustment),Capital. RORAC makes a risk adjustment to the
denominator by selecting economic capital based on the shape of the gain/loss distribution:
RORAC = Return,(Capital Risk Adjustment).
This list is not exhaustive. Many consulting rms, such as Coopers and Lybrand, have introduced
variants of RAPM such as RARORAC (risk-adjusted return on risk-adjusted capital):
RARORAC = (Return Risk Adjustment),(Capital Risk Adjustment).
Journal of Risk
M. Crouhy et al. 6
The implicit assumption is that the RAROC measure adjusts the risk of a
business to that of a rm's equity. Consequently, if a rm is considering
investing in a business (or closing a business down), it can compute the RAROC
for the business and compare it with the rm's cost of equity capital. If the
RAROC number is greater than the rm's cost of the equity capital, the business
will add value to the rm. The RAROC methodology avoids having to calculate
the beta for the business. It measures risk by using the current probability of
default for the rm.
In Section 2 we examine the underlying premise of RAROC: that it is possible
to construct a risk-adjusted rate of return such that it can be compared with a
rm's cost of equity capital. We do this using the contingent claims framework
of Merton (1974). We consider a business that is nanced in such a way that the
expected rate of return on equity equals some prespecied value. We then
compute the probability of default. We show, not surprisingly, that while it is
possible to pick a capital structure so as to achieve a required rate of return on
equity, the probability of default will change as the volatility of the rate of return
on the rm's assets changes.
We also show that while it is possible to pick a capital structure so that the
probability of default equals some prespecied level, the expected rate of return
on equity will change as the volatility of the rate of return on the rm's assets
changes.
In Section 3 we consider an all equity rm undertaking a risky investment.
The rm sets up a reserveeconomic capitalso that the probability of default
remains constant at some prespecied level. We show that risk-adjusted
performance measures such as RAROC change as the risk of the business
changes, even though the probability of default is kept constant. We then
introduce an alternative measure that corrects the problem: adjusted RAROC.
In Section 4 we consider the RAROC of a bank's loan portfolio. We
demonstrate that RAROC varies as the volatility of the assets underlying the
loan varies, due to changes in the level of the rm's economic capital, even
though the probability of the rm defaulting on its loan is kept constant.
Businesses within a rm are typically correlated with each other. In the
RAROC methodology, economic capital for each business is determined by
treating each business in isolation. The economic capital for the rm takes into
account the covariances between the dierent businesses. The sum of the
economic capital for each business is typically greater than the economic capital
for the rm. One common method of addressing this problem is to introduce a
weighting scheme, where it is assumed that the economic capital for a stand-
alone business is proportional to the economic capital of the rm. We show in
Section 5 that such a method can introduce major errors.
Section 6 presents some closing comments. We consider some of the
incentives generated by a RAROC methodology. If compensation decisions
are based on RAROC, senior management may benet at the expense of
shareholders.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 7
2. PURE FINANCING DECISION
A premise of RAROC is that it keeps the probability of default constant and
can be directly compared with the rm's cost of equity capital. In this section
we show that this premise is awed: maintaining the probability of default
constant is inconsistent with a constant expected rate of return on equity and
vice versa.
In the following we consider a rm that undertakes a project and adjusts its
capital structure so that the probability of default is set at some prespecied level
and we then compute the expected rate of return on equity capital for two cases.
First, we alter the volatility of the rm's risky assets, adjust the rm's capital
structure so that the probability of default is kept constant, and compute the
expected rate of return on equity capital. We show that keeping the probability
of default constant does not imply that the cost of equity capital is invariant to
changes in the risk of the rm's assets. In the second case the rm undertakes a
pure nancing decision to achieve a degree of leverage so that the expected rate
of return on equity equals some prespecied level. We compute the probability
of default. We alter the volatility of the rm's risky assets and adjust the rm's
capital structure so that the expected rate of return on equity is kept constant.
We show that the probability of default is not invariant to changes in the risk of
the rm's assets even if the expected rate of return on equity is kept constant.
2.1 The Model
We consider a rm that undertakes a pure nancing decision to alter its degree
of leverage so that the probability of default is kept constant at some
prespecied level. To start we assume that the rm is totally nanced by equity.
The rm issues zero-coupon debt and with the proceeds repurchases equity.
Capital markets are assumed to be frictionless and for simplicity there is no
form of corporate or personal taxation. Corporate debt is risky, as default can
occur. If default occurs, bondholders take over the rm. It is assumed that there
are no transaction costs associated with default and consequently capital
structure is irrelevant (see Merton 1977).
Let A(t) denote the market value of the rm's assets at time t. The rm issues
zero-coupon debt with face value F. The debt matures at date T. Let D(tY T)
denote the market value of the rm's debt at time t. At maturity the payo to
bondholders is
D(TY T) =
F if A(T) bF,
A(T) if A(T) - F,
_
(2)
Looking at the right-hand side of expression (2), the payo to bondholders is
composed of two terms. The bondholders receive the face value of debt, F, and
a put option is written. This put option will be exercised against the bondholders
if default occurs. Let S(t) denote the market value of equity at time t. The value
Journal of Risk
M. Crouhy et al. 8
of equity at date T is
S(T) =
A(T) F if A(T) bF,
0 if A(T) - F,
_
(3)
which is the payo to a European call option on the rm's assets with strike
price F. The total market value of the rm equals the sum of the market value of
equity plus the market value of debt:
A(t) S(t) D(tY T) for 0 Tt TT. (4)
The expected rate of return on equity is
"
R
S
{E[S(T)] S(0)],S(0). (5)
To compute this expected rate of return, we need to impose some assumptions
about the specication of changes in the market value of the assets.
2.2 Valuation
Following Merton (1974), it is assumed that
dA(t)
A(t)
= j
A
dt o
A
dW(t). (6a)
where j
A
is the instantaneous expected rate of return, o
A
is the volatility, and
W(t) is a Brownian motion. It is assumed that j
A
and o
A
are constant, implying
that A(t) is lognormally distributed. Hence, we can write
A(t) = A(0) exp[(j
A

1
2
o
2
A
)t o
A
W(t)]. (6b)
where W(t) is normally distributed with zero mean and variance t. Following
Merton (1974), assuming that the default free rate of interest is deterministic
over the period [0. T] and using expression (6) implies that the market value of
debt and equity at time 0 is given by
D(0Y T) = FB(0Y T) p[A(0). TY F] (7)
and
S(0) = c[A(0). TY F]. (8)
where B(0Y T) is the value of a Treasury bill that pays one dollar for sure at date
T; p[A(0). TY F] and c[A(0). TY F] respectively represent the value of a European
put and call option described by
p[A(0). TY F] = FB(0Y T)N(d
2
) A(0)N(d
1
). (9)
with
d
1
{ln[A(0),FB(0Y T)]
1
2
o
2
A
T],o
A

T
_
and d
2
d
1
o
A

T
_
.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 9
Here N( ) is the cumulative normal distribution function, and
c[A(0). TY F] = A(0)N(d
1
) FB(0Y T)N(d
2
). (10)
The expected value of equity is
E[S(T)] = A(0)(exp jT)N(d
+
1
) FN(d
+
2
). (11a)
where
d
+
1
= {ln[A(0),F] (j
A

1
2
o
2
A
)T]
_
o
A

T
_
and d
+
2
= d
+
1
o
A

T
_
. (11b)
Note that, in contrast to the denitions of d
1
and d
2
in expression (9), d
+
1
and d
+
2
are dened in terms of the instantaneous expected rate of return j
A
on the
rm's risky assets. In calculating the expected value of equity, we use the natural
(or objective) probability distribution and not the equivalent martingale
distribution.
The expected rate of return on equity is dened by expression (5). By altering
the capital structure of the rm and thus the face value F of the zero-coupon
debt, we can vary the expected rate of return on equity.
2.3 Probability of Default
The probability that default occurs is
p
+
= Pr[A(T) TF [ A(0)].
Using expression (6b), we can write
p
+
= Pr
_
Z T
ln[F,A(0)] (j
A

1
2
o
2
A
)T
o
A

T
_
_
.
where Z is normally distributed with zero mean and unit variance. Hence,
p
+
= N(d
+
2
). (12)
where d
+
2
is dened in expression (11b).
Two observations can be made about expression (12). First, the probability of
default is calculated using the distribution that describes the changes in the
market value of the assets, as described by expression (6). This is dierent from
the equivalent martingale distribution used to calculate the option prices in
expressions (9) and (10). Second, because the ordinary probability distribution is
used, the expected rate of return on the assets appears in expression (12), and
consequently there will be a trade-o between the expected rate of return and
volatility in determining the probability of default.
Journal of Risk
M. Crouhy et al. 10
2.4 Example
The capital asset pricing model can be written in the form
"
R
A
R
f
= ,o
A
(
"
R
M
R
f
),o
M
= [
A
(
"
R
M
R
f
). (13)
where
"
R
A
is the expected rate of return on the risky asset;
2
R
f
is the default free
rate of interest; , is the correlation coecient between the rate of return on the
risky asset and the rate of return on the market portfolio; o
A
is the standard
deviation of the rate of return on the risky asset;
"
R
M
is the expected rate of
return on the market portfolio; and o
M
is the standard deviation of the rate of
return on the market portfolio. The beta, or systematic risk of the rm's assets,
is given by [
A
= ,o
A
,o
M
.
Keeping the probability of default constant
The probability of default is given by expression (12). If we vary the asset
volatility o
A
, then to keep the probability of default constant, which is
equivalent to keeping d
+
2
constant in expression (11b), we must vary the capital
structure of the rm.
By increasing the volatility of the rate of return on the risky asset, this
increases the beta coecient ([
A
= ,o
A
,o
M
) and hence the expected rate of
return. Both systematic and idiosyncratic risk will also increase.
3
The results are
shown in Table 1. In this example, the probability of default is specied to
be 1%.
In Part A the correlation coecient , is set at 0.25. If the volatility of the
return on the risky asset increases, this causes the equilibrium expected rate of
return on the risky asset to increase. To maintain the probability p
+
of default
constant, the debt to equity ratio needs to be adjusted downward, while the
expected rate of return on equity increases. In Part B, the correlation coecient
is set at 0.50. Similar results are obtained.
Comparing Part A and Part B, consider the case of the standard deviation
being 5%. Owing to the higher correlation in Part B than in Part A, the expected
rate of return on the risky asset is higher in Part B, and consequently the debt to
equity ratio is also higher in Part B in order to keep the probability of default
constant. The expected rate of return on equity is 10.46% in Part A, compared
with 16.28% in Part B. Table 1 illustrates both the importance of the correlation
coecient and the counterfactual nature of the premise behind RAROC:
2
"
R
A
is the annualized discretely compounded rate of return on the assets of the rm and is related
to the continuously compounded rate of return j
A
in expression (6a) via the relationship
j
A
= ln(1
"
R
A
).
3
The variance of the rate of return on the risky asset can be decomposed into two components,
systematic risk and idiosyncratic risk:
o
2
A
= [
2
o
2
M
o
2
I
= ,
2
o
2
A
o
2
I
.
where o
2
I
is the variance due to idiosyncratic risk. If the return on the risky asset is less than perfectly
correlated with the return on the market portfolio, [,[ - 1, then an increase in the variance of the
rate of return on the risky asset will increase the systematic risk, ,
2
o
2
A
, and increase the idiosyncratic
risk, o
2
I
= (1 ,
2
)o
2
A
.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 11
keeping the probability of default constant is inconsistent with a constant
expected rate of return on equity for projects with dierent volatilities and
correlations with the market portfolio.
Keeping the expected rate of return on equity constant
The capital structure is altered so that the expected rate of return on equity
equals the target expected rate of return. In this example, the target expected rate
of return is set at 17%. For a xed value of the correlation coecient ,, we vary
the volatility o
A
of the rate of return on the risky asset. Increasing the volatility
of the rate of return on the risky asset increases the expected rate of return on the
rm's assets, and this will decrease the required degree of leverage to achieve the
target expected rate of return on equity. The results are shown in Table 2.
The striking dierence between the results in Part A and Part B is that the
probabilities of default are an order of magnitude higher in Part A than in Part
B. An increase in the correlation coecient, keeping volatility constant,
increases the expected rate of return on the risky asset and decreases the degree
of leverage necessary to reach the target return on equity. This lowers the
probability of default, which is inversely related to the asset's expected rate of
return and directly related to the face value of debt.
TABLE 1. Altering the capital structure to keep the probability of default constant:
p
+
= 17.
Standard
deviation,
o
A
(%)
Expected rate
of return on
the risky assets,
"
R
A
(%)
Face value
of debt,
F
Market values Expected rate
of return on
equity,
"
R
S
(%)
Debt, D(0Y T) Equity, S(0)
Part A: Correlation coecient , = 0.25
5 5.70 939.8 893.7 106.3 10.46
10 6.27 838.0 796.8 203.2 10.71
20 7.42 661.2 628.4 371.6 11.25
40 9.71 399.4 379.3 620.7 12.48
Part B: Correlation coecient , = 0.50
5 6.27 944.9 898.5 101.5 16.28
10 7.42 847.0 805.2 194.8 16.77
20 9.71 675.3 641.7 358.3 17.81
40 14.29 416.1 394.9 605.1 20.21
Probability of default: p
+
= N(d
+
2
) 1%
Default free rate of interest,
a
R
f
5.13%
Expected rate of return on the market portfolio,
a
"
R
M
12.0%
Volatility of the return on the market portfolio, o
M
15.0%
Market value of assets 1000
Maturity of debt 1 year
a Expressed as a discretely compounded rate of return.
Journal of Risk
M. Crouhy et al. 12
3. PROJECT EVALUATION
We now examine the use of risk-adjusted performance measures in determining
whether to accept or reject an investment project. We start by considering an all
equity nanced rm. The price per share is denoted by s
0
and the number of
shares by n
0
. Initially, the only asset of the rm is cash g, where g = n
0
s
0
. We
relax this assumption in Section 5.
The rm is assumed to undertake a risky investment. The cost of the
investment is denoted by I. The market value of the risky assets is denoted by
A(0). The stochastic process describing changes in the market value of the risky
asset is given by expression (6). The rm also sets up a reserve fund G of cash so
that the probability of default after it undertakes the investment is equal to some
prespecied level p
+
. We refer to G as the economic capital of the rm. To
nance the investment, the rm raises I (G g) in cash by issuing zero-
coupon debt and additional equity. After undertaking the investment, the rm's
assets are A(0) and G. The reserve fund is invested in a default free asset,
generating a rate of return R
f
.
The market value of the zero-coupon debt is denoted by D(0Y T). The debt
matures at date T. The number of new shares of equity is denoted by m and the
TABLE 2. Altering the capital structure to keep the expected rate of return on equity
constant:
"
R
S
= 177.
Standard
deviation,
o
A
(%)
Expected rate
of return on
the risky assets,
"
R
A
(%)
Face value
of debt,
F
Market values Probability
of default,
p
+
= N(d
+
2
)
(%)
Debt, D(0Y T) Equity, S(0)
Part A: Correlation coecient , = 0.25
5 5.70 1024.7 965.1 34.9 27.56
10 6.27 993.8 927.9 72.1 26.73
20 7.42 919.6 846.7 153.3 24.92
40 9.71 728.2 660.7 339.3 20.48
Part B: Correlation coecient , = 0.50
5 6.27 952.1 905.2 94.8 1.48
10 7.42 851.4 809.3 190.7 1.15
20 9.71 647.7 615.8 384.2 0.56
40 14.29 239.8 228.1 771.9 0.01
Default free rate of interest,
a
R
f
5.13%
Expected rate of return on the market portfolio,
a
"
R
M
12.0%
Volatility of the return on the market portfolio, o
M
15.0%
Market value of assets 1000
Maturity of debt 1 year
a Expressed as a discretely compounded rate of return.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 13
new equilibrium price per share by s(0).
4
The total market value of equity is
denoted by S(0), where
S(0) (n
0
m)s(0). (14)
The total amount of nancing is
D(0Y T) ms(0) I (G g). (15)
3.1 Valuation of Equity and the Credit-Risky Debt
The market value of the risky investment is described by expression (6).
5
The
payo to the debt holders is
D(TY T) =
F if A(T) G(1 R
f
) bF,
A(T) G(1 R
f
) if A(T) G(1 R
f
) - F.
_
(16)
The above expression can be written in the form
D(TY T) = F
0 if A(T) bK,
K A(T) if A(T) - K,
_
(17)
where K F G(1 R
f
) and can be interpreted as the net indebtness of the
rm, measured at time T. The rm has issued risky debt with a face value F and
can use its economic capital G to help pay o bondholders in the event that the
value A(T) of the risky assets is less than the face value F of the debt. Using the
results from expression (7), the market value of the risky debt is given by
D(0Y T) = FB(0Y T) p[A(0). TY K]. (18)
The promised rate of return R
P
on the credit risky debt is dened by
D(0Y T) F,(1 R
P
) (19)
using discrete compounding.
Following from expression (8), the market value of equity is given by
S(0) = c[A(0). TY K]. (20)
3.2 The Probability of Default
The level of economic capital G is set such that, given debt has a face value F,
the probability of default equals some prespecied value p
+
:
p
+
= Pr[A(T) G(1 R
f
) TF] = Pr[A(T) TK]. (21)
4
If m is negative, this means that shares are repurchased. Note that n
0
m > 0.
5
Note that A(0) = I only for a zero net present value investment. Otherwise A(0) is greater or less
than I, depending on whether the investment has a positive or negative net present value.
Journal of Risk
M. Crouhy et al. 14
where K F G(1 R
f
). If G(1 R
f
) > F, the probability of default is zero,
since the net indebtness of the rm is negative. We assume that the rm is a net
borrower, so that there is a positive probability of default. Using expression (12),
we get
p
+
= N(d
+
2
). (22)
where d
+
2
{ln[A(0),K] (j
A

1
2
o
2
A
)T],o
A

T
_
. The value of p
+
is specied by
senior management. Given p
+
, expression (21) implies the value of K, that is,
K = A(0) exp[(j
A

1
2
o
2
A
)T o
A

T
_
N
1
(p
+
)]. (23)
where N
1
( ) is the inverse of the cumulative normal distribution function.
Given K, we can immediately determine the market value of equity, using
equation (20), and the default put option p[A(0). TY K] in expression (18). To
determine the market value of debt, we must make some assumption about the
debt/equity nancing of the investment I (G g). Note that K and F and G
are related by the expression
G = (F K)B(0Y T). (24)
3.3 Calculating RAROC
The market value of equity at time T is given by
S(T) = A(T) G(1 R
f
) D(TY T).
Hence, the expected value of equity is
E[S(T)] = E[A(T) G(1 R
f
)] E[D(TY T)]
E[A(T)] G(1 R
f
) D(0Y T)(1
"
R
D
). (25)
where
"
R
D
is the expected rate of return on debt. The expected rate of return on
equity to new shareholders is
"
R
E
E[S(T)],S(0) 1. (26)
The expected rate of return to existing shareholders is
"
R
/
E

E[S(T)],(n
0
m)
s
0
1. (27)
Up to this point we have made no assumption about the debt equity mix used
in the nancing of the project. In calculating RAROC a common assumption is
that the risky asset is totally nanced by debt, implying that
I = D(0Y T). (28)
with economic capital G being nanced by the initial cash position g and new
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 15
equity (see expression (15)). RAROC is then dened as the expected return on
economic capital:
6
RAROC = {E[A(T) G(1 R
f
) D(0Y T)(1
"
R
D
)],G 1
= E[S(T)],G 1. (29)
Comparing expression (29) with the expected rate of return to new shareholders
(expression (26)) and the expected rate of return to existing shareholders
(expression (27)), it is seen that it is generally dierent from the expected rate
of return to equity shareholders, as rst observed by Wilson (1992).
According to Zaik et al. (1996), Bank of America uses a xed hurdle rate
the bank's cost of equity capital. It is well known that this produces two types of
error: accepting `high-risk' projects that will decrease the value of the rm and
rejecting `low-risk' projects that will increase the value of the rm (see Brealey
and Myers 1996). Zaik et al., while recognizing the errors that may occur, argue
that the costs of estimating individual betas for dierent businesses outweigh the
benets. This raises two questions. First, how is the expected rate of return to
existing shareholders related to RAROC? Second, how sensitive is the RAROC
methodology to changes in the risk of the underlying business?
Appendix A proves the following proposition relating RAROC to the
expected rate of return to existing and new shareholders.
Proposition 1 Assuming that the risky asset is totally nanced by debt
(expression (28)) and that the market value of debt is less than the market value
of the risky assets, D(0Y T) - A(0), we have:
(1) for a positive net present value project,
"
R
/
E
> RAROC >
"
R
E
Y
(2) for a zero net present value project,
"
R
/
E
= RAROC =
"
R
E
Y
(3) for a negative net present value project,
"
R
E
> RAROC >
"
R
/
E
.
where
"
R
E
is the expected rate of return to new shareholders and
"
R
/
E
is the expected
rate of return to existing shareholders.
Proof. See Appendix A. &
The interesting aspect of Proposition 1 is that we have not used any type of
valuation model in deriving the relative ordering of the expected rates of return.
The result is simply a consequence of the denition of RAROC. The proposition
6
This expression is completely consistent with the expression in footnote 1, recognizing that the risk
adjustment is the economic capital G.
Journal of Risk
M. Crouhy et al. 16
shows that, for zero net present value projects, the expected rate of return on
equity for both the new and the existing shareholders and RAROC are equal.
This provides some credence for comparing RAROC to the rm's cost of equity
capital for stand-alone projects (see Zaik et al. 1996).
Proposition 1 suggests an appropriate hurdle rate for accepting or rejecting a
project. In equilibrium the expected rate of return to equity shareholders is given
by the capital asset pricing model (see expression (13)):
"
R
E
R
f
= [
E
(
"
R
M
R
f
).
where [
E
is the beta of equity. From Proposition 1, a project will increase the
wealth of existing shareholders if
"
R
/
E
R
f
[
E
>
RAROC R
f
[
E
> R
M
R
f
. (30)
assuming [
E
> 0. We dene the adjusted RAROC measure to be
Adjusted RAROC
RAROC R
f
[
E
. (31)
3.4 Properties of RAROC
To examine some of the properties of RAROC, we consider two examples that
are extensions of the example described in Section 2.4. First, we consider a zero
net present value investment. The volatility of the return on the risky asset is
varied, keeping xed the correlation coecient between the return on the risky
assets and the return on the market portfolio.
7
This aects the systematic risk of
the project [
A
and its expected rate of return. The probability of default is kept
constant, implying that the level of the economic capital must be adjusted as the
volatility of the risky asset and its expected rate of return change.
The RAROC value is calculated using (29) and the adjusted RAROC
measure using expression (31). The beta for equity is estimated using the capital
asset pricing model and the fact that equity is a call option on the assets of the
rm (see expression (20)):
[
E
=
A(0)
S(0)
N(d
1
)[
A
. (32)
where [
A
is the beta coecient of the risky assets. The use of expression (32)
represents an approximation. It is an instantaneous beta, and not a discrete time
beta. This introduces a small error.
The sensitivity of the RAROC measure to changes in the volatility of the
risky asset are shown in Table 3. The project is a marginal project with zero net
present value, as the market value A(0) of the risky asset equals the cost I of the
investment. Therefore, we should be indierent to the project. We also observe
that, as expected from Proposition 1, RAROC and the expected rate of return to
7
Beta is related to the correlation coecient via [ = ,
AM
o
A
,o
M
.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 17
equity are equal. The adjusted RAROC is just equal to the expected excess rate
of return on the market portfolio, that is,
"
R
M
R
f
= 6.877.
Four points are worth noting. First, RAROC is sensitive to the level of the
standard deviation of the risky asset. This is to be expected, given our results
from the last section. Second, RAROC is sensitive to the correlation of the
return on the underlying asset and the market portfolio. Third, the adjusted
RAROC measure is relatively insensitive to changes in volatility and correlation.
Fourth, if, as described by Zaik et al. (1996), we follow Bank of America's use of
a xed hurdle rate, we would pick high volatility and high correlation projects.
The results in Table 3 show that RAROC depends upon the level of volatility.
This suggests that, for large volatility, RAROC may be suciently large that it is
above the required hurdle rate. Hence a project, with a negative net present value
may well be accepted. We consider a minor variation of the example used in
Table 3 by altering the cost I of the investment. In the rst case we set I = 1050,
implying a negative net present value: the share price declines to $9.50 per share
from $10 per share. In the second case we set I = 1000, implying a zero net
present value: the share price remains unchanged at $10 per share. This case was
already considered in Table 3. In the third case we set I = 950, implying a
TABLE 3. Sensitivity of RAROC to volatility for a zero net present value investment.
Standard
deviation,
o
A
(%)
Expected rate of return (%) Economic
capital,
G
RAROC
(%)
Adjusted
RAROC
(%)
Risky asset,
"
R
A
Equity,
"
R
E
Part A: Correlation coecient 0.25
5 5.70 10.46 106.3 10.46 6.88
10 6.27 10.71 203.2 10.71 6.88
20 7.42 11.25 371.6 11.25 6.88
40 9.71 12.48 620.7 12.48 6.88
Part B: Correlation coecient 0.50
5 6.27 16.28 101.5 16.28 6.90
10 7.42 16.77 194.8 16.77 6.90
20 9.71 17.81 358.3 17.81 6.89
40 14.29 20.21 605.1 20.21 6.88
Default free rate of interest,
a
R
f
5.13%
Expected rate of return on the market portfolio,
a
"
R
M
12.0%
Volatility of the return on the market portfolio, o
M
15.0%
Market value of the risky assets, A(0) 1000
Cost of investment, I 1000
Initial value of the rm, g 1000
Initial number of shares, n
0
100
Maturity of debt, T 1 year
Probability of default, p
+
1%
a Expressed as a discretely compounded rate of return.
Journal of Risk
M. Crouhy et al. 18
positive net present value: the share price increases to $10.50 per share from $10
per share. The results are given in Table 4.
Looking along the rows, it is seen that the variation in RAROC depends
upon the level of volatility. For low volatility, RAROC is relatively sensitive as to
whether the project has positive or negative net present value. The level of
sensitivity decreases as the level of volatility increases. RAROC is an increasing
function of net present value. Suppose the net present value decreases. This
implies that the numerator in RAROC decreases and the denominator increases,
and hence RAROC decreases.
The variation of RAROC with volatility depends upon whether the project
has positive or negative net present value. If the project has positive net present
value, the variation of RAROC with volatility is U-shaped. For zero and
negative net present value projects, RAROC increases as volatility increases.
RAROC depends upon the variation of E[A(T)],G and I(1
"
R
D
),G with
volatility. The level of reserves G declines as the net present value increases.
For zero and negative net present value projects, the change in E[A(T)],G is
larger than the change in I(1
"
R
D
),G for a given increase in volatility. This
explains why RAROC increases as volatility increases. This is also the case for
positive net present value projects when volatility is large. For low volatility, the
reverse holds.
The results in Table 4 show that, for a project with high volatility and negative
net present value, the RAROC value may be suciently large so as to be above an
investment hurdle rate, i.e. 17% in our example. The adjusted RAROC provides
TABLE 4. Net present value and RAROC.
Standard
deviation
(%)
Negative Zero Positive
RAROC Adjusted
RAROC
RAROC Adjusted
RAROC
RAROC Adjusted
RAROC
5 10.82 3.52 16.18 6.90 22.31 10.62
10 13.84 5.16 16.77 6.90 19.84 8.72
20 16.19 6.01 17.81 6.89 19.48 7.80
40 19.22 6.43 20.21 6.88 21.21 7.34
Price per share,
s(0)
9.50 10.00 10.50
Default free rate of interest,
a
R
f
5.13%
Expected rate of return on the market portfolio,
a
"
R
M
12.0%
Volatility of the return on the market portfolio, o
M
15.0%
Original price per share, s
0
10.00
Market value of assets, A(0) 1000
Maturity of debt, T 1 year
Correlation coecient, , 0.50
a Expressed as a discretely compounded rate of return.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 19
the correct investment decision. For negative net present value investment
projects it is below the hurdle rate, and for positive net present value projects
it is above the hurdle rate, where adopting adjusted RAROC the corresponding
hurdle rate becomes the expected excess return on the market portfolio,
"
R
M
R
f
.
The adjusted RAROC is equal, below, or above the expected excess return on the
market portfolio, that is, 6.87%, when the net present value of the project is zero,
negative, or positive respectively. This is true for all levels of volatility.
3.5 Estimating the Adjusted RAROC
The adjusted RAROC dened by expression (31) requires that we measure the
beta of the equity. It is commonly argued that the whole reason for RAROC is
that it adjusts for risk without requiring that we measure beta. However, as we
have demonstrated, RAROC does not adjust for risk and consequently we are
faced with the problem of estimating beta.
Expression (32) provides us with a mechanism to estimate beta. First,
experience typically allows us to estimate the value A(0) of the assets, their
volatility o
A
, and beta [
A
. We must estimate the term N(d
1
), where
d
1
= {ln[A(0),K] (r
1
2
o
2
A
)T]
_
o
A

T
_
.
The probability of default is given by expression (22). If we know the beta of the
assets, then we know the required rate of return j
A
(see expression (13)). Given
an estimate of the probability of default, we can use expression (23) to infer the
parameter K. Hence we are in a position to estimate d
1
and S(0), using
expression (20). Consequently, we can estimate all the terms on the right-hand
side of expression (32).
3.6 Value-at-Risk and Economic Capital
We end this section with a brief discussion of the denition of economic capital
and the relationship between economic capital and value-at-risk. We have
dened the rm's economic capital as being equal to the reserves G that the
rm keeps so that the probability of default is equal to some prespecied level
p
+
. This is not the denition of economic capital that is used in practice.
Normally, it is dened as the dierence between the expected future value of the
rm's assets and the value-at-risk. The value-at-risk v for the rm is dened as
the critical value for which the probability of the rm's risky assets being less
than or equal to v is equal to some specied value p
++
. We can write this in the
form
p
++
= Pr[A(T) Tv].
The standard practice is to set p
++
equal to the desired probability of default p
+
.
This implies that, by comparison with expression (21), v = K.
The standard denition of economic capital is
EC E[A(T)] v = A(0) exp(j
A
T) K.
Journal of Risk
M. Crouhy et al. 20
Substituting expression (24), we have
EC = A(0) exp(j
A
T) F G(1 R
f
)
= (1 R
f
){A(0) exp[(j
A
r
f
)T] FB(0Y T) G].
where r
f
is the continuously compounded default free interest rate. The above
expression implies that the traditional denition of economic capital may
overestimate or underestimate the correct economic capital.
8
4. A BANK'S LOAN PORTFOLIO
Bankers Trust originally introduced the RAROC methodology to measure the
performance of its loan portfolio. In this section we examine the performance of
a loan portfolio by extending the model described in the last section. It is
assumed that the bank purchases the credit-risky debt issued by a rm. The
bank nances the loan by borrowing. The bank requires a reserve fund G
B
of
cash so that the probability of default is equal to some prespecied level p
+
B
. The
reserve fund is referred to as the bank's economic capital.
To simplify the analysis, we assume that before undertaking this investment
the bank is all equity nanced. The only asset of the bank is cash g
B
. Let I
B
denote the cost to the bank of purchasing the bond from the rm or alternatively
advancing a loan to the rm. The total cost of the investment is I
B
(G
B
g
B
),
which is nanced by borrowing D(0Y T) and issuing additional equity. We
assume that the loan advanced to the rm is nanced by the bank borrowing
the amount I
B
. At time T, the bank must pay the amount I
B
(1 R
B
), where R
B
is the bank's cost of borrowing.
The probability of default is
p
+
B
= Pr[D(TY T) G
B
(1 R
f
) TI
B
(1 R
B
)]. (33)
where D(TY T) is described by expression (16). Let
K
B
I
B
(1 R
B
) G
B
(1 R
f
) (34)
8
A slightly more sophisticated denition denes economic capital as the present value of the
dierence between the expected future value of the rm's assets and the value-at-risk:
EC = PV[A(T) F G(1 R
f
)].
If the risk of default is ignored, then the promised rate on debt R
P
(see expression (19)) is equal to
the expected rate
"
R
D
(see expression (25)). Hence
F = D(0Y T)(1 R
P
) = D(0Y T)(1
"
R
D
).
Using this expression, the economic capital is
EC = PV[S(T)] = S(0).
Hence, for a zero net present value project, EC = G. Furthermore, G is less (greater) than EC for
negative (positive) net present value projects. While this is an interesting result, it ignores default and
hence is a rst-order approximation at best.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 21
denote the net payment the bank must make at time T. Expression (33) can then
be written as
p
+
B
= Pr[D(TY T) TK
B
]. (35)
If K
B
> F, then default by the bank is certain. The maximum the bank will
receive from the bond payment is F, which is less than the bank's obligation,
implying default will occur with certainty. We will assume that the bank follows
a strategy where default does not occur with certainty, implying K
B
TF. Let D
B
denote the event of default by the bank and D the event of default by the rm.
The probability of default by the bank is
Pr(D
B
) = Pr(D
B
[ D) Pr(D). (36)
the proof being given in Appendix B.
The rm will default if the value of its assets is less than K, that is, if the event
A(T) - K occurs (see expression (21)). Conditional on default by the rm, the
rm pays the bank the amount A(T) G(1 R
f
). The bank will default on its
obligations if
A(T) G(1 R
f
) - K
B
. (37)
The probability of default by the bank conditional on default by the rm is
Pr(D
B
[ D) = Pr[A(T) G(1 R
f
) - K
B
[ A(T) - K].
Let
K
/
B
K
B
G(1 R
f
). (38)
so that
Pr(D
B
[ D) = Pr[A(T) - K
/
B
[ A(T) - K] =
1 if K
/
B
> K,
Pr[A(T) - K
/
B
] if K
/
B
TK.
_
(39)
The unconditional probability of default by the bank is
Pr(D
B
) =
Pr(D) if K
/
B
> K,
Pr(D) Pr[A(T) - K
/
B
] if K
/
B
TK.
_
(40)
The case K
/
B
> K occurs when the rm is more conservative than the bank.
Default by the rm triggers default by the bank. The probability of default for
the bank is thus determined by the rm.
4.1 Calculating RAROC
The expected payment at date T to the bank from the rm can be written, using
expression (17), in the form
F E[K A(T) [ A(T) - K]. (41)
Journal of Risk
M. Crouhy et al. 22
where the second term is the expected value of the loss, given default. Using
expression (29), the value of RAROC is
RAROC = {F E[K A(T) [ A(T) - K] G
B
(1 R
f
) I
B
(1 R
B
)],G
B
1.
(42)
assuming G
B
> 0.
4.2 Example
The risky debt issued by the rm, described in Section 3.4, is purchased by the
bank. The bank nances the purchase by debt. We assume that the bank sets its
reserves so that the probability of default over the one year period is 0.01%,
which is consistent with Moody's expected default frequency for an A credit-
rated company. We compute the RAROC of the loan to the bank using
expression (42). For simplicity, we assume that cost of borrowing for the bank
is the risk-free rate of interest.
9
While this introduces a slight error, it is common
practice to use the risk-free rate. The results are shown in Table 5.
In Part A, the probability of default for the rm is assumed to be 1.79%,
TABLE 5. RAROC for a bank's loan portfolio
Standard
deviation,
o
A
(%)
Expected rate of return
for the rm's:
Bank's
economic
capital, G
RAROC
(%)
Risky assets,
"
R
A
Debt,
a
"
R
D
Part A: Probability of default for the rm 1.79%
5 6.27 5.15 19 6.37
10 7.42 5.15 34 6.35
20 9.71 5.19 55 6.32
40 14.29 5.20 68 6.26
Part B: Probability of default for the rm 8.31%
5 6.27 5.23 72 6.61
10 7.42 5.32 130 6.62
20 9.71 5.45 210 6.66
40 14.29 5.55 267 6.73
Default free rate of interest, R
f
5.13%
Expected rate of return on the market portfolio,
"
R
M
12.0%
Volatility of the return on the market portfolio, o
M
15.0%
Correlation coecient, , 0.50
Market value of assets, A(0) 1000
Maturity of debt, T 1 year
Probability of default for the bank, p
+
0.01%
a Expressed as a discretely compounded rate of return.
9
In practice, the LIBOR interest rate is used and it is implicitly assumed that there is no chance of
default by the bank.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 23
which is consistent with Moody's Ba credit rating. In Part B, the probability of
default is assumed to be 8.31%, which is consistent with Moody's B credit
rating.
Two interesting observations can be made about the results in Table 5. First,
RAROC varies as the volatility of the rm's risky assets change, even though the
probability of default for the rm and the bank are held constant. Second,
RAROC can be an increasing or decreasing function of the volatility of the
rm's risky assets depending upon its credit rating. For low credits, RAROC
increases as volatility increases.
5. DIVERSIFICATION AND ECONOMIC CAPITAL
For a rm with dierent businesses, the economic capital for a particular
business can be determined by viewing the business on a stand-alone basis.
The stand-alone economic capital is often used for measuring the performance
of dierent businesses within the rm. The economic capital for the rm as a
whole is normally less than the sum of the economic capital of the individual
businesses determined on a stand-alone basis, because the businesses are not
perfectly correlated. For entry/exit decisions, it is necessary to determine the
marginal economic capital, not the stand-alone economic capital. This raises the
practical diculty of how to measure the marginal economic capital.
One common method of addressing this problem is to introduce a weighting
scheme, where it is assumed that the economic capital for a stand-alone business
is proportional to the economic capital of the rm. Let EC
j
denote the stand-
alone economic capital of the jth business within the rm. Let EC
B
denote the
economic capital for the rm as a whole. Dene
w EC
B
_

n
i=1
EC
i
. (43)
where n is the number of businesses within the rm. Note that the right-hand
side does not depend explicitly upon the particular business j, and 1 w
represents the portfolio diversication eect. The marginal economic capital
for the jth business is given by
wEC
j
. (44)
The sum of the marginal economic capitals for the businesses is

n
j=1
wEC
j
= EC
B
. (45)
as expected.
Journal of Risk
M. Crouhy et al. 24
5.1 Valuation of Equity and the Credit-Risky Debt
We start by describing the rm and then the investment project to be undertaken
by the rm.
The market value of the rm's assets is described by expression (6). The rm
has zero-coupon debt with a face value F. The debt matures at date T. The rm
also has a reserve fund G of cash so that the probability of default over the
period (0. T] is equal to some prespecied level p
+
. The value of the rm's debt is
described by expression (17), with K, the strike price of the put option, being
given by expression (23). The level of the rm's economic capital is described by
expression (24).
The rm undertakes an investment project. The cost of the investment is I
1
.
The market value of the investment project is A
1
(0). The stochastic process
describing changes in the market value of the investment project is
dA
1
(t)
A
1
(t)
= j
1
dt o
1
dW
1
(t). (46)
where j
1
is the instantaneous expected rate of return, o
1
is the volatility, and
W
1
(t) is a Brownian motion. In general, changes in the market value of the
project are correlated with changes in the value of the rm's existing assets. The
project is assumed to be value additive, so that the value of the rm after it
undertakes the project is
V(t) A(t) A
1
(t). (47)
The stochastic process describing the value of the rm is, in general, not
lognormal, as the sum of lognormal distributions is not lognormal. For
computational ease, we will, however, assume that the distribution can be
approximated by a lognormal distribution by matching the rst two moments
(j
V
. o
V
) of the distribution. The details are described in Appendix C. The
accuracy of this assumption is examined in Levy and Turnbull (1992).
The project is assumed to be totally nanced with debt. The rm also wants
to alter the amount of cash reserves to the level G
1
so that the probability of
default remains unchanged at the prespecied level p
+
. The total cost of the
investment is I
1
(G
1
G) and it is nanced by issuing zero-coupon debt and
equity.
The number of new shares of equity is denoted by m and the new equilibrium
price per share by s(0). The total market value of equity is denoted by S(0),
where
S(0) (n
0
m)s(0). (48)
where n
0
is the number of shares in the rm before the project. The investment I
1
is assumed to be nanced by issuing zero-coupon debt that matures at date T.
The rm already has zero-coupon debt outstanding with a face value F that
matures at the same date. After the rm has nanced the investment project, it
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 25
will have debt outstanding with a total face value F
1
and market value D
1
(0Y T).
Let
D
1
(0Y T) F
1
d
1
(0Y T). (49)
where d
1
(0Y T) is the market value of a zero-coupon bond with a face value of 1,
given that the rm has F
1
such bonds. Given that the rm has announced it will
undertake the investment, the market value of the rm's original debt is
Fd
1
(0Y T), so that the market value of the new debt issues is (F
1
F)d
1
(0Y T),
where
(F
1
F)d
1
(0Y T) = I
1
. (50)
Substituting expression (49) into expression (50) gives
D
1
(0Y T)(1 F,F
1
) = I
1
. (51)
Using expression (23), the probability of default p
+
implies
K
1
= V(0) exp[(j
V

1
2
o
2
V
)T o
V

T
_
N
1
(p
+
)]. (52)
where j
V
is the instantaneous expected rate of return for the rm and o
V
the
volatility of the return. The above expression determines K
1
. Given expression
(50) and K
1
, the value of the zero-coupon can be determined as
D
1
(0Y T) = F
1
B(0Y T) p[V(0). TY K
1
. o
V
]. (53)
using expression (17). The total value of equity is given by
S
1
(0) = c[V(0). TY K
1
. o
V
]. (54)
using expression (20). The level of reserves is given by
G
1
= (F
1
K
1
)B(0Y T). (55)
5.2 Calculating RAROC
In general, the eects of correlation between the investment project and the risky
assets of the rm are nonlinear. Correlation aects the value of the put option
that bondholders have implicitly written, and hence the value of existing debt,
the economic capital, and RAROC. One case that allows a simple analysis is
that of a scale-expanding project. To be precise, we dene a scale-expanding
project to be of the form
A
1
(t) = oA(t). (56)
where o is a positive constant. The project is nanced so that the capital
structure of the rm remains unchanged. Expression (56) implies that the return
on the project is perfectly positively correlated with the original risky assets of
the rm.
Proposition 2 For a scale-expanding project that is nanced such that the
capital structure remains unchanged, the economic capital is also scale expanding.
Journal of Risk
M. Crouhy et al. 26
That is,
G
1
G = oG. (57)
Proof. See Appendix D. &
This proposition implies that the marginal economic capital is equal to the
stand-alone economic capital. In general, this is not the case for non-scale-
expanding projects. To explore the eects of correlation, we consider a
numerical example using the theory described in Section 5.1.
5.3 Example
The initial conditions of the rm are given in Table 6. These gures are taken
from Table 3, Part B. The rm has issued zero-coupon debt with a current
market value of 1000. The debt matures in one year's time. The rm undertakes
an investment project. The market value A
1
(0) of the project is assumed to
be 1000.
In Table 7, Part A, the cost I
1
of the project is assumed to equal 1000,
implying the project has zero net present value. We alter the correlation
coecient ,
IM
of the project with the market portfolio, keeping the volatility
o
1
constant. Once the correlation coecient ,
AM
of the return on the rm's
existing risky assets with the market portfolio is specied, then the correlation
coecient ,
AI
between the return on the project and the rm's existing assets is
determined as
,
AI
= ,
AM
,
IM
. (58)
assuming a one-factor model of asset returns.
10
The project is rst considered in isolation. We increase the correlation
coecient of the project's rate of return with the return on the market portfolio.
This increases the project's beta coecient and hence its expected rate of return.
The volatility of the rate of return of the project is kept constant. The probability
10
Let the return on the market portfolio be described by
dM
M
= j
M
dt o
M
dW
M
.
The return on the existing assets of the rm is described by
dA
A
= jdt o
AM
dW
M
o
AI
dW
A
.
where W
M
and W
A
are independent Brownian motions. The return on the investment project is
described by
dA
I
A
I
= j
1
dt o
IM
dW
M
o
II
dW
I
.
where W
M
, W
A
, and W
I
are independent Brownian motions.
The correlation coecient of the existing assets of the rm with the market is
,
AM
o
AM
,o
A
and, for the investment project,
,
IM
o
IM
,o
I
.
The correlation coecient of the existing risky assets of the rm and the investment project is
,
AI
o
AM
o
IM
,o
A
o
I
= ,
AM
,
IM
.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 27
of default is also kept constant, so that the strike price K increases as the
correlation coecient increases. From equation (24), this implies that the
economic capital decreases. The stand-alone RAROC value increases. The
results are similar to those in Table 3.
Next, the project and the rm's existing risky assets are considered together.
As we increase the correlation coecient ,
IM
of the project's rate of return with
the return on the market portfolio, the correlation ,
AI
between the project and
the rm's existing risky assets also increases, given expression (58).
For the economic capital of the project and rm together, two opposing
eects must be considered. An increase in the correlation coecient of the risky
project with the market increases the project's expected rate of return. This will
have the eect of increasing the strike price K
1
. However, an increase in the
correlation coecient of the risky project with the market increases the
correlation coecient ,
AI
of the project with the existing risky assets of the
rm. This has the eect of increasing the volatility o
V
and lowering the strike
TABLE 6. Initial state of the firm.
Market value of debt, D(0Y T) 1000
Market value of equity, S(0) 358
Economic capital, G 358
Volatility, o
A
20%
Correlation coecient with the market, , 0.5
Beta of the risk assets, [
A
0.667
Probability of default, p
+
1%
Maturity of debt, T 1 year
RAROC 17.81%
TABLE 7. Investment project with present value A
1
(0) = 1000 and volatility o
1
= 207.
Project Correlation
with market,
,
IM
Correlation
with rm,
,
AI
Project
stand-alone basis
Project
and the rm
Economic
capital, G
RAROC Economic
capital, G
RAROC
Part A: Zero net present value
1 0.25 0.125 372 11.25 562 17.21
2 0.50 0.250 358 17.81 575 20.89
3 0.75 0.375 345 24.85 588 24.44
4 1.00 0.500 332 32.43 599 27.87
Part B: Negative net present value
1 0.25 0.125 377 9.77 567 16.18
2 0.50 0.250 363 16.19 581 19.85
3 0.75 0.375 350 23.07 593 23.39
4 1.00 0.500 337 30.46 604 26.81
Journal of Risk
M. Crouhy et al. 28
price K
1
. In Table 7 the increase in volatility eect dominates and hence the
economic capital increases. For RAROC, the decrease in the strike price and the
increase in the expected rate of return increase the expected future value of
equity and hence RAROC. Osetting this increase is the increase in economic
capital that, everything else being equal, will cause RAROC to decrease. In this
case, the net eect causes RAROC to increase.
For the valuation of debt, the associated put option is deep-out-of-the-
money, because the prespecied probability of default is set at 1%. Con-
sequently, the change in the value of the put option is small when the rm
undertakes the risky investment, implying that wealth transfer eects between
bond and equity holders can be ignored.
For an investment project with negative net present value, the results are very
similar, as shown in Table 7, Part B.
Marginal economic capital
Tables 6 and 7 allow us to compute the marginal economic capital and to
compare it with the method described by expression (44). The results are shown
in Table 8. We have computed the marginal economic capital using the results in
Table 7.
11
It is seen in Table 8 that there is a wide discrepancy between the two
sets of values. The weighting scheme is insensitive to the project's systematic risk
(beta) with the market.
Projects with constant beta coefcient
In Table 9, we vary the correlation of the project with the market such that the
project's beta (systematic risk) remains constant. This implies that the expected
rate of return on the project remains unchanged. If the correlation of the project
TABLE 8. Marginal economic capital of the investment
project.
Project Marginal
capital
Weighting
scheme
Part A
1 204 286
2 217 288
3 230 289
4 241 288
Part B
1 209 291
2 223 293
3 235 293
4 246 293
11
For project 1, the marginal economic capital is 562 358 = 204. For the weighting scheme,

2
j=1
EC
j
= 358 372 = 730, implying w
j
= 562,730 = 0.7699. The economic capital for the
project is 0.7699 372 = 286.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 29
with the market increases, then the volatility of the project must decrease, given
the assumption of a constant beta, and the correlation with the rm will increase
(see expression (58)). Increasing the correlation of the project with the market
with the resulting decrease in the project's volatility implies that the project's
stand-alone economic capital decreases and also the economic capital of the
project and the rm together decreases. Consequently RAROC increases. For
estimating the marginal economic capital, the weighting scheme can produce
large errors.
6. CLOSING COMMENTS
To maximize the risk-adjusted return on economic capital, subject to constraints
imposed by regulatory requirements, is a dictum followed by many banks. We
have shown that commonly employed methods may result in decisions that
adversely aect shareholder value. We have described an alternative methodo-
logy, adjusted RAROC, that corrects the inherent limitations of the existing
methods.
6.1 Games with RAROC
We end this paper by examining the incentives that a RAROC methodology
TABLE 9. Beta of project constant.
Part A
Project Standard
deviation
Correlation
with
market
Correlation
with
rm
Project
stand-alone basis
Project
and the rm
Economic
capital
RAROC Economic
capital
RAROC
1 60 0.25 0.125 785 13.13 1114 14.88
2 30 0.50 0.250 499 17.76 712 20.35
3 20 0.75 0.375 350 23.07 593 23.39
4 15 1.00 0.500 263 28.94 543 25.04
Market of project A
1
(0) = 1000.
Cost of investment I
1
= 1005.
Part B
Project Marginal
capital
Weighting
scheme
1 756 765
2 354 414
3 235 293
4 185 230
Journal of Risk
M. Crouhy et al. 30
generates for senior management. The initial state of the rm is as described in
Table 6. The current RAROC value for the rm is 17.81%.
Game 1
In Table 10, Part A, we consider four mutually exclusive investment projects.
The marginal economic capital, as estimated by the weighting scheme is
approximately the same for all the projects. On a stand-alone basis, project 4
has the highest RAROC. When we consider the RAROC value of the rm and
project together, project 4 again comes out top. Advocates of RAROC would
pick project 4. Unfortunately, there is a problem. Project 4 has negative net
present value, and will decrease the wealth of existing shareholders.
Game 2
In Table 10, Part B, we consider four mutually exclusive investment projects.
The rm's RAROC before undertaking any new investment projects is 17.81%.
We see that project 1 will lower the rm's RAROC, while the remaining projects
will increase the rm's RAROC value. Advocates of RAROC would reject
project 1, and accept one of the remaining projects. Unfortunately, there is a
problem. The remaining projects have negative net present value, and will
TABLE 10. Games with RAROC.
Part A: Game 1
Project Project
stand-alone basis
Marginal
economic
capital
Weighted
economic
capital
RAROC
rm and
project
Economic capital RAROC
1
a
358 17.81 217 288 20.89
2
a
345 24.85 230 289 24.44
3
b
350 23.07 235 293 23.39
4
b
337 30.46 246 293 26.81
a From Table 7, Part A.
b From Table 7, Part B.
Part B: Game 2
Project Firm and project together
RAROC of project
and the rm
Economic
capital
1
a
17.21 562
2
b
19.85 581
3
b
23.39 593
4
b
26.81 604
a From Table 7, Part A.
b From Table 7, Part B.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 31
decrease the wealth of existing shareholders. Project 1, which was rejected, has
zero net present value.
If compensation for senior management is based on RAROC, then the
methodology provides incentives for management to undertake investments
that can increase RAROC, but decrease the wealth of existing shareholders.
APPENDIX
A. Proof of Proposition 1
We rst consider the expected rate of return to new shareholders. Given the
assumption that I = D(0Y T), expression (15) can be rewritten in the form
ms(0) = G g.
so that G = ms(0) n
0
s
0
. For a nonnegative net present value project s(0) bs
0
,
implying that
GT(m n
0
)s(0) = S(0).
Hence,
1,Gb1,S(0).
Given limited liability, then E[S(T)] b0, so that
E[S(T)],G 1 bE[S(T)],S
0
1.
Hence,
RAROC b
"
R
E
. (A1)
For a negative net present value project,
RAROC -
"
R
E
. (A2)
Next we consider the expected rate of return to original shareholders. For a
nonnegative net present value project, s(0) > s
0
, we have
Gb(m n
0
)s
0
.
implying that
"
R
/
E
bRAROC. (A3)
For a negative net present value project
"
R
/
E
- RAROC. &
B. The Bank's Loan Portfolio
Let
"
D denote the event the rm does not default on its bond and D the event
that the rm defaults. Suppose that the rm does not default. Then the bank
receives the payment F. The conditional probability that the bank will default
Journal of Risk
M. Crouhy et al. 32
is
Pr[D
B
[
"
D
A
] =
1 if F - K
B
Bank defaults,
0 if F b K
B
Bank does not default.
_
(B1)
If K
B
> F, then default will occur with certainty, implying that
Pr[D
B
] = 1. (B2)
Suppose that the rm defaults on its bond payment. The bank receives the
amount A(T) G(1 R
f
). The bank will default if A(T) G(1 R
f
) - K
B
.
Hence,
Pr[D
B
[ D] = Pr[A(T) G(1 R
f
) - K
B
[ D]. (B3)
Now
Pr[D
B
] = Pr[D
B
[
"
D] Pr[
"
D] Pr[D
B
[ D] Pr[D]. (B4)
For K
B
TF, using equation (B1), we obtain
Pr[D
B
] = Pr[D
B
[ D] Pr[D]. (B5)
C. Two Risky Assets
By assumption,
A
i
(T) = A
i
(0) exp[(j
i

1
2
o
2
i
)T o
i

T
_
Z
i
] (i = 1. 2).
where Z
1
and Z
2
are bivariate normally distributed with correlation coecient ,;
Z
i
N(0. 1). Let V(t) A
1
(t) A
2
(t). It is assumed that the distribution of
V(T) can be approximated by a lognormal distribution:
V(t) = V(0) exp[(j
V

1
2
o
2
V
)T o
V

T
_
Z
V
].
where Z
V
N(0. 1). The moments j
V
and o
2
V
are chosen to match the rst two
moments of A
1
(T) A
2
(T):
E[A
1
(T) A
2
(T)] =

2
i=1
A
1
(0) exp(j
i
T) V(0) exp(j
V
T). (C1)
Expression (C1) denes j
V
.
For the second moment,
E[{A
1
(T) A
2
(T)]
2
] = E[A
1
(T)
2
] 2E[A
1
(T)A
2
(T)] E[A
2
(T)
2
]
= A
1
(0)
2
exp(j
1
T o
2
1
T)
2A
1
(0)A
2
(0) exp[(j
1
j
2
)T o
1
o
2
,T]
A
2
(0)
2
exp(2j
1
T o
2
2
T)
V(0)
2
exp(2j
V
T o
2
V
T). (C2)
Expression (C2) denes o
2
V
.
Volume 2/Number 1, Fall 1999
Measuring risk-adjusted performance 33
D. Proof of Proposition 2
By assumption, A
1
(0) = oA(0) (o > 0), so that
V(0) = (1 o)A(0). (D1)
In expression (52), recognizing that j
V
= j and o
V
= o, we have, by comparison
with expression (23),
K
1
= (1 o)K. (D2)
Given the assumption of lognormality, options are homogeneous of degree 1 in
A(0) and K. Hence,
p[A
1
(0). TY K
1
. o] = (1 o)p[A(0). TY K. o]. (D3)
and
c[A
1
(0). TY K
1
. o] = (1 o)c[A(0). TY K. o]. (D4)
Since
V(0) = D
1
(0Y T) S
1
(0). (D5)
it follows that (D1) and (D4) imply that
D
1
(0Y T) = (1 o)D(0Y T). (D6)
Expressions (D3) and (D6) imply that
F
1
= (1 o)F. (D7)
Expressions (D2) and (D7) imply that
G
1
= (1 o)G. (D8)
Acknowledgements
The views expressed in this paper are those of the authors and do not necessarily
reect the position of the Canadian Imperial Bank of Commerce. The rst draft
of this paper was written when Lee Wakeman was a consultant for CIBC. The
authors gratefully acknowledge comments from Robert Mark and the Editor,
Philippe Jorion.
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Measuring risk-adjusted performance 35