AIM 1: Define strategic capital allocation.

1、Which of the following is NOT a consideration in the strategic capital allocation process?

A) The firm’s strategic opportunities in its industry.

B) The risks of a business unit.

C) The risk embedded in the balance sheet of the bank.

D) The growth rate of a business unit. 

The correct answer is A

Strategic capital allocation involves assigning return objectives to the business units of a bank to determine the optimal economic capital to those individual business units. This would not include examining the firm’s strategic opportunities in its industry.

2、Strategic capital allocation is defined as:

A) the method for maximizing market value added.

B) the quintessential application of bottom-up analysis.

C) None of the above.

D) the assigning of return objectives to the business units of a bank. 

The correct answer is D

The assigning of return objectives to the business units of a bank is the general philosophy behind strategic capital allocation.

AIM 2: Discuss the top-down and bottom-up approaches to capital allocation, including the difference between product and business risk.

1、Which of the following would NOT be a step in the top-down approach to capital allocation?

A) Estimate the distributions of losses for an individual portfolio.

B) Set the capital limits for a business unit.

C) Control the economic capital consumption by each business unit in a period.

D) Assess the risk and return for a business unit.

The correct answer is A

The top-down approach assesses the risk and return of each business unit and allocates the total capital of the bank accordingly. The steps in the top-down approach to capital allocation include setting capital limits for the business units, controlling the economic capital consumption by each business unit in the period, and reassessing these limits for the next period.

2、The variability of revenues of an online bookseller is best described as:

A) credit risk.

B) business risk.

C) seasonal risk.

D) active risk.

The correct answer is B

Business risk is the variability of revenues depending on the type of business the firm operates in. Credit risk is the risk of default or widening of spreads. Active risk is the tracking error risk (with respect to a benchmark) for an active portfolio manager. There is no such thing as seasonal risk.

3、In strategic capital allocation, all of the following steps are part of a bottom-up approach EXCEPT to:

A) estimate the distribution of losses for each portfolio.

B) limit concentration.

C) control the economic capital consumption by each business unit in the period.

D) select the projects based on the hurdle rate.

The correct answer is C

Controlling the economic capital consumption by each business unit in the period is part of a top-down approach.

AIM 3: Define and compare the six methods of allocating economic capital.

1、Which of the following methods of allocating economic capital uses a bottom-up approach?

A) Internal betas method.

B) Marginal capital method.

C) Arbitrage pricing theory (APT) method.

D) Scaling method.

The correct answer is D

The scaling method of capital allocation is a bottom-up approach. This method calculates economic capital for a homogeneous portfolio that corresponds to an appropriate business unit.

2、Which of the following models of capital allocation estimates the economic capital for a bank and then estimates the economic capital that would be needed without a particular business unit?

A) RAROC-based proportional scaling rule.

B) Incremental capital allocation rule.

C) Fair value allocation rule.

D) Stand-alone method.

The correct answer is B

The incremental capital allocation rule attempts to assess the economic capital required for a bank and then estimate what the economic capital that would be needed without one of the business units. The ratio of each business unit’s marginal capital divided by the aggregate marginal capital gives an estimate of the fraction of economic capital to assign to the business unit.

3、Of the six methods of allocating economic capital, the one that explicitly incorporates a VAR methodology is the:

A) incremental capital allocation rule. 

B) fair value allocation rule. 

C) RAROC-based proportional scaling rule.

D) stand-alone, market-based allocation rule. 

The correct answer is B

The fair value method or “fair value allocation rule” measures the net asset value of each business unit “j” (NAVj) using discounted cash flow or some other approach. Then the method requires two values: 1) an estimate of the volatility of the NAVj over the designated horizon and 2) an appropriate confidence level. The economic capital for each unit is essentially the value at risk (VAR) of the NAVj given the two inputs. “RAROC-based proportional scaling rule” is not the best answer because the calculation may be based on VAR or some other bottom-up methodology.

4、Of the six methods of allocating economic capital, the one that is bottom-up in nature is the:

A) RAROC-based, proportional scaling method.

B) stand-alone, market-based allocation method.

C) incremental capital allocation method.

D) fair value allocation method.

The correct answer is A

The RAROC-based proportional scaling method uses a bottom-up process to calculate economic capital for homogeneous portfolios corresponding to the business units.

AIM 4: Explain how liquidity and information affect strategic capital allocation.

The selling of liquid positions by banks is:

A) legal but not recommended.

B) legal and recommended.

C) illegal.

D) None of the above.

The correct answer is B

Having only illiquid assets on the balance sheet allows the bank to focus on those types of assets

AIM 5: Discuss the strengths and weaknesses of linking RAROC and EVA to develop a dynamic capital allocation model.

1、With respect to the development of a dynamic capital allocation model, which of the following is TRUE?

A) RAROC is a bottom-up approach, and EVA is a top-down approach.

B) RAROC is a top-down approach, and EVA is a bottom-up approach.

C) RAROC and EVA both use top-down approaches.

D) RAROC and EVA both use bottom-up approaches.

The correct answer is A

EVA is a top-down process, and the RAROC process is bottom-up. EVA uses market information, and RAROC relies more on accounting information.

2、A problem with linking EVA and RAROC in the development of a dynamic capital allocation model is that:

A) a fixed hurdle rate will lead banks to adopt countercyclical behavior.

B) EVA and RAROC are both bottom-up approaches, which lowers diversification.

C) None of the above.

D) a fixed hurdle rate will lead banks to adopt procyclical behavior.

The correct answer is D

EVA uses market information, and RAROC relies more on accounting information. This can produce problems such as procyclical behavior by banks if they measure RAROC with a fixed hurdle rate.

The correct answer is D

EVA uses market information, and RAROC relies more on accounting information. This can produce problems such as procyclical behavior by banks if they measure RAROC with a fixed hurdle rate.