Risk‐Adjusted Measures of Value Creation in Financial Institutions

24 Pages Posted: 23 Aug 2012

See all articles by Alistair Milne

Alistair Milne

Loughborough University - School of Business and Economics

Mario Onorato

City University London - Sir John Cass Business School

Multiple version iconThere are 2 versions of this paper

Date Written: September 2012

Abstract

Many financial institutions assess portfolio decisions using RAROC, the ratio of expected return to risk (or ‘economic’) capital. We use asset pricing theory to determine the appropriate hurdle rate, finding that this varies with the skewness of asset returns. We quantify this discrepancy under a range of assumptions showing that the RAROC hurdle rate differs substantially, being higher by a factor of five or more for equity which has a right skew compared to debt which has a pronounced left skew, and also between different qualities of debt exposure. We discuss implications for both financial institution risk management and supervision.

Keywords: asset pricing, banking, capital allocation, capital budgeting, capital management, corporate finance, downside risk, economic capital, economic value added, performance measurement, RAROC, risk management, hurdle rate, value at risk

JEL Classification: G22, G31

Suggested Citation

Milne, Alistair K. L. and Onorato, Mario, Risk‐Adjusted Measures of Value Creation in Financial Institutions (September 2012). European Financial Management, Vol. 18, Issue 4, pp. 578-601, 2012. Available at SSRN: https://ssrn.com/abstract=2134706 or http://dx.doi.org/10.1111/j.1468-036X.2010.00540.x

Alistair K. L. Milne (Contact Author)

Loughborough University - School of Business and Economics ( email )

Epinal Way
Loughborough
Leicestershire, LE11 3TU
United Kingdom

Mario Onorato

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
0
Abstract Views
561
PlumX Metrics