Allocation of risk capital on an internal market

Baule, Rainer

doi:10.1016/j.ejor.2013.09.005

Cited by 15 publications

(5 citation statements)

References 47 publications

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“…The first article, demonstrating the usefulness of RAROC for this purpose is Stoughton and Zechner (2007). Extensions of this work are Buch et al (2011), Baule (2014), Turnbull (2018) and Kang and Poshakwale (2019) where the latter even empirically demonstrate the usefulness of this approach. In this article, we do not analyze capital allocation on the business unit level but assume that this is done already.…”

Section: Literature Reviewmentioning

confidence: 71%

A Raroc Valuation Scheme for Loans and Its Application in Loan Origination

Engelmann

Pham

2020

Risks

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In this article, a risk-adjusted return on capital (RAROC) valuation scheme for loans is derived. The critical assumption throughout the article is that no market information on a borrower’s credit quality like bond or CDS (Credit Default Swap) spreads is available. Therefore, market-based approaches are not applicable, and an alternative combining market and statistical information is needed. The valuation scheme aims to derive the individual cost components of a loan which facilitates the allocation to a bank’s operational units. After its introduction, a theoretical analysis of the scheme linking the level of interest rates and borrower default probabilities shows that a bank should only originate a loan, when the interest rate a borrower is willing to accept is inside the profitability range for this client. This range depends on a bank’s internal profitability target and is always a finite interval only or could even be empty if a borrower’s credit quality is too low. Aside from analyzing the theoretical properties of the scheme, we show how it can be directly applied in the daily loan origination process of a bank.

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Section: Literature Reviewmentioning

confidence: 71%

A Raroc Valuation Scheme for Loans and Its Application in Loan Origination

Engelmann

Pham

2020

Risks

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“…We next consider the calibration of risk estimates when the project selection has to fulfil constraints on downside risk. In practice, such constraints may be required due to regulations on allowed risk levels or agreed risk budgets (Baule 2014, Kubo et al 2005. The DM may also impose a risk constraint when the realization of a risky outcome of the portfolio selection problem would cause severe harm to the organization.…”

Section: Downside Risk Constrained Project Portfolio Selectionmentioning

confidence: 99%

“…1980, Nawrocki 1999, Sortino and van der Meer 1991). Frequently, downside risk constraints are included in portfolio selection problems due to regulations or risk budgeting (Baule 2014, Kubo et al. 2005, Stamatelatos and Dezfuli 2011).…”

Section: Literature Reviewmentioning

confidence: 99%

Section: Downside Risk Constrained Project Portfolio Selectionmentioning

confidence: 99%

“…Subsequently, downside risk measures have become widely employed in portfolio problems (Eppen et al 1989, Hall et al 2015, Menezes et al 1980, Nawrocki 1999, Sortino and van der Meer 1991. Frequently, downside risk constraints are included in portfolio selection problems due to regulations or risk budgeting (Baule 2014, Kubo et al 2005, Stamatelatos and Dezfuli 2011. It is also possible to assess downside risk in order to anticipate and prepare for risky outcomes.…”

Section: Literature Reviewmentioning

confidence: 99%

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Estimation of Downside Risks in Project Portfolio Selection

Kettunen

Salo

2017

Production and Operations Management

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In project portfolio selection, the aim is to choose projects which are expected to offer most value and satisfy relevant risk and other constraints. In this study, we show that uncertainties about how much value the projects will offer, combined with the fact that only a subset of the proposed projects will be selected, lead to inaccurate risk estimates about the aggregate value provided by the selected project portfolio. In particular, when downside risks are measured in terms of lower percentiles of the distribution of portfolio value, these risk estimates will exhibit a systematic bias. For deriving unbiased risk estimates, we present a calibration framework in which the required calibration can be presented in closedform in some cases or, more generally, derived by using Monte Carlo simulation to study a large number of project selection decisions. We also show that when the decision must comply with risk constraints, the introduction of tighter (more demanding) risk constraints can counterintuitively aggravate the underestimation of risks. Finally, we present how the calibrated risk estimates can be employed to align the portfolio with the decision maker's risk preferences while eliminating systematic biases in risk estimates.

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Internal Capital Budgeting and Allocation in Financial Firms

Kang¹

2021

Encyclopedia of Finance

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Allocation of risk capital on an internal market

Cited by 15 publications

References 47 publications

A Raroc Valuation Scheme for Loans and Its Application in Loan Origination

A Raroc Valuation Scheme for Loans and Its Application in Loan Origination

Estimation of Downside Risks in Project Portfolio Selection

Internal Capital Budgeting and Allocation in Financial Firms

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