hard · FRM Part 2 Operational Risk
An analyst is calculating the RAROC for a retail credit portfolio using the Basel IRB framework. The portfolio has a Probability of Default (PD) of 2.5%, a downturn Loss Given Default (LGD) of 45%, and an asset correlation ρ of 0.15.
If the analyst accidentally uses the 'cycle-average' LGD of 30% instead of the 'downturn' LGD, what is the specific impact on the RAROC result?
- The RAROC will be overstated because both the EL deduction in the numerator and the UL capital in the denominator are understated.
- The RAROC will be overstated because the numerator is reduced by a smaller EL, while the denominator remains fixed by regulatory floors.
- The RAROC will be understated because the lower LGD reduces the investment income earned on capital.
- The RAROC will remain unchanged as LGD is only a component of expected loss, which is provisioned outside the RAROC framework.
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