Bank AAA is considering a loan to be fully funded by deposits, with the following parameters: Loan amount: GBP 3 million

Average annual interest rate paid on deposits: 1.5% Annual interest rate on loan: 4.0%

Expected loss: 1.0% of face value of loan

Annual operating costs: 1.0% of face value of loan

Economic capital: 8.0%

Average return on economic capital: 3.0% What is the risk-adjusted return on capital for this loan?

A. 9.25%

B. 10.25%

C. 21.75%

D. 34.25%

Answer: A

Explanation:

Expected revenue = 3 billion *4%=120 million Expenses (cost of fund)=3 billion *1.5%=45 million Expected losses =3 billion*1.0%= 30 million

Return on economic capital =3 billion *8% *3%=7.2 million Expenses (operating)=3 billion *1%=30 million

The risk adjusted return= Expected revenue-Expenses-Expected losses+ Return on economic capital +(-) transfer price =120-45-30+7.2-30=22.2 RAROC+=Risk adjusted return/ economic capital =22.2/240=9.25%

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