DP2344 | Optimal Capital Allocation Using RAROC And EVA

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This paper analyzes financial institutions' capital allocation decisions when their required equity capital depends on the risk of their projects chosen. We discuss the relevance of strict position limits against discretionary trading through the use of an optimal compensation function. We show that (under full information) the first-best investment decision can be delegated through an economic value added (EVA) compensation contract and solve for the optimal capital allocation rules. We demonstrate how the concept of incremental Value at Risk must be used to deal with the multidivisional firm. The results are extended to deal with asymmetric information on the part of the trading division(s). The analysis defines precisely the notion of risk-adjusted return on capital (RAROC) and how it can be used as a performance measure.