Hi Colin, Thank you for being patient with my never ending questions, here is another one on VaR and Capital allocation April 2005 Ques. Paper Ques. 1 part iii The question says calculate allocated capital and solved it using EAR, which is fine. But we can calculate using RAROC too, right? That is the calculation I need to discuss: RAROC=Revenue-cost-"Expected Loss"/VaR SO we can say, allocated capital=Revenue-cost-Expected Loss/RAROC= Mortgage Lending Revenue=30 Expected Annual cost=20m Expected loss=1m Target return on capital=10% Capital = (30-20-1)/10%=90m. Do you agree? Secondly, the question says 95% VaR for Mortgage lending =0, does that mean there is no loss ie downside risk for Mortage lending at 95th %ile? Does not sound intuitive to me or I am missing something? Thirdly, in chapter 13, question 13.2 I am unable to follow, which is dealing with net and gross measure. Lastly, the old version of ques. bank part 4, ques. 1 part 1 says " This is typically done using a measure such as: (Revenues RAROC costs 'expected' losses) VaR Revenues would be the typical annual revenue from the business line. Costs would be the costs incurred in managing that business. It is often better to include the “cost of capital” in this item as well, particularly where one business line (such as loans) requires capital to be invested and the other (futures dealing) requires no lending of capital. So in the case of the bank in question we would include “capital invested ¥ cost of capital” as part of the costs of the loan business, whereas the futures business would only have the physical costs of running the business such as salaries and rents etc." My question is following from the previous part discussion of Gross and Net measure, "Capital Invested*Cost of capital", should this not be capital ALLOCATED and should be for both Bank and futures business as both need capital allocated? Thanks in advance for your help. Kind Regards ishita
Your calculation of 90m seems justifiable. I am sure that would also have gained marks. The VaR of 0 means that the 5% one-sided tail starts at 0. this means that the mean profit must be sufficient to offset even this one-in-twenty event. Doesn't sound that likely, but it is indeed what the examiner is suggesting. The Net measure will include the cost of the capital allocated to the division. This is not included in a gross measure. I am not 100% sure about your point on the difference between capital allocated and capital invested. As I see it, any capital allocated to a business unit would also be capital invested by that unit, s the measures would be similar. Certainly both bank and futures trading divisions would need allocated capital, as they both expose the bank to risk. The futures division would need only the capital. The bank division would need capital buffer and a great deal of borrowed resources (eg depositors).
