June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 89 of 92 RAROC rankings thereby optimizing the firm’s return on incremental equity or risk capital. Another property of this decomposition method is that the CEQi of all the investments in the portfolio will add up to the total required equity of the firm’s portfolio. Therefore, all the business units’ CEQi should add up to the firm’s portfolio equity. Likewise, all of the investment CEQi in a business unit should add up to the business unit’s required equity. This property allows us to allocate or charge each business units/investments a capital charge for the risk exposure created by the business units/investments in the firm’s diversified portfolio38. The ability to charge individual business units or investments for their required equity allows the firm to monitor performance on a risk-neutralized playing field. The firm can now calculate each business unit’s return on the incremental equity or risk capital required to support their business activity. Each business unit is then charged on how much risk exposure that its business activities add to the firm. Using this capital charge, a backward-looking RAROC can be calculated to determine the business unit’s risk- neutralized return to the firm. By penalizing risk, this metric will discourage managers from taking unnecessary risk in order to increase their returns. To determine the component credit risk, operative risk and/or market risk, one can calculate their CEQi by determining their associated expected credit loss, operative loss or market loss at default. Thus the credit risk’s CEQ would represent the value destruction at default created by credit exposures that the firm’s portfolio could not diversify. The current practice is to calculate stand alone credit, operative and market VaR and acknowledge that the diversified portfolio VaR will not equal the sum of these standalone VaRs because of diversification. However, this method allows us to calculate the true impact that their risk has on the firm’s required equity. 10.2.9. Impact of New Marketing Activities on Hedging Strategy EMTCo management wished to maintain their original 5.25% default rate while undergoing the expansion project. They were concerned that the 1% increase in the default rate created by the expansion project (without increasing equity) may eventually lower their border-line investment grade credit rating into a non-investment grade category. Nonetheless, they did not want to raise the previously calculated $75MM in additional equity required to offset the risk of the expansion project and allow the company to maintain its original default rate. The CRO recommended evaluating ways the company could hedge away the new risk exposure created by the expansion activities without raising the additional capital. The company had previously only employed 38 There will be a difference between the firm’s required economic capital and the portfolio’s required economic capital because of interest expense and dividends. Part of the value lost at default or required economic capital is due to these cash outflows that are not attributed to any specific investment. One can either allocate this value lost across business units/investments, use the portfolio required economic capital which will be reduced by this loss value, or just recognize that the sum of all the investments’ CECi will be equal to the portfolio’s required economic capital and less than the firm’s required economic capital.