XYZ Bank Limited uses risk-adjusted return on capital (RAROC) to measure performance on several aspects. In this regard, imagine that a bank officer wants to execute a transaction with the following characteristics: Probability of default (PD) = 35 basis points Loss given default (LGD) = 55% Exposure at default (EAD) = US$ 1.45 million Expected loss (EL) = US$ 2,750 This is a loan to a company in the agricultural sector. The bank's economic capital (EC) model is based on the 99% confidence level, with an average standard deviation of 2.15%. The risk-free rate of return is 6%. Assume that the bank has set a RAROC hurdle rate of 15% and this transaction has a net profit of US$ 10,500. Required: D. Compute the bank's risk-adjusted rate of return on this transaction. [6 Marks] E. Now assume that XYZ Bank could also have made a loan for the same amount to a firm in the service industry, and that the standard deviation for economic capital purposes in this case is 1.29%. Compute the bank's risk-adjusted rate of return on this transaction? [6 Marks] F. Which loan between the two entities should the bank grant and why?

Answer rating: 100% (QA)

D To compute the banks riskadjusted rate of return on the transaction we can use the formula for RAROC RAROC Net Profit Expected Loss Economic Capital ... View the full answer