New Kwacha Bank uses RAROC model to evaluate performance of its business lines. The RAROC model, computed for each specific activity, measures the ratio of the expected yearly net income to the yearly VAR risk estimate.

REQUIRED:

You are asked to estimate the RAROC of its K$500$ million loan business. The average interest rate is $10\%.$ All loans have the same probability of default of $2\%$ with a loss given default $($LGD$)$ of $50\%.$ Operating costs are K$10$ million. The funding cost of the business is K$30$ million. RAROC is estimated using a credit$-$VAR for loan businesses, in this case, $7\mathrm{.}5\%.$ The economic capital is invested and earns $6\%.$

A$.$ How does the RAROC differ with the traditional measures of performance?

$(5$ Marks$)$

B$.$ Calculate the RAROC using the above information. $(15$ Marks$)$