Determining hurdle rate and capital allocation in credit portfolio management

Abstract

We examine two interrelated issues in risk-adjusted return on capital performance measurement: estimating hurdle rates and allocating capital to debt instruments in a portfolio. We consider a methodology to differentiate hurdle rates for individual debt instruments that incorporates obligor-specific information. These instrument-specific hurdle rates, which define the required compensation of the shareholders, enable a granular differentiation of systematic risk among debt contracts. Using the proposed approach, we show that the hurdle rate could be materially different among industry sectors and obligors of different credit quality. Profitability assessment could be significantly distorted if the difference in hurdle rates is ignored.

Valuation Insight: Miu, Ozdemir, Cubukgil, and Giesinger consider the use by financial institutions of the risk-adjusted return on capital which is compared to the shareholders’ required rate of return to allow a financial institution to find out if an asset or a line of business is creating value for its shareholders. They find that using alternative instrument-specific risk-adjusted return measures is better and creates more value for shareholders.