Chapter 30 SHV

[ALEX_AK]

Hello, should the formula for SHV be,
Capital x [(RAROC - g)/(hurdle rate - g)]
The rate is missing?
Also, how did we derive the above formula?
Capital x [(RAROC - g)/(hurdle rate - g)]
= Capital x [(Risk-adj return/Capital - g)/(hurdle rate - g)]
= [(Risk-adj return - Capital*g)/(hurdle rate - g)]
I understand the denominator is based on the perpetuity formula (1/i) with growth rate g.
But the numerator should be Risk-adj return - Capital, ie without the g?
(Risk-adj return - Capital) can be interpreted as, cashflows received after deducting capital is the profit.
But why do we have Capital*g. How do we interpret this?

 

[Simon James]

Hi, yes "hurdle" is abbreviation of "hurdle rate"

You can't deduct Capital from Risk-adj return. A bank's capital will be many multiples of its return (cf profit) - this would always be negative. Factoring in the g gives the return in excess of some expected return on capital (eg consider g as the risk-free rate)

Another way to think about it might be the dividend discount model? The numerator is dividends, which is the return being generated by the company less the growth (ie return = d + g, so d = return - g)?

 

[ALEX_AK]

Hi Simon, thanks a lot. Your explanation is very clear.