A theory of risk capital

Isil Erel, Stewart C. Myers and James A. Read

Journal of Financial Economics, 2015, vol. 118, issue 3, 620-635

Abstract: We present a theory of risk capital and of how tax and other costs of risk capital should be allocated in a financial firm. Risk capital is equity investment that backs obligations to creditors and other liability holders and maintains the firm׳s credit quality. Credit quality is measured by the ratio of the value of the firm׳s option to default to the default-­free value of its liabilities. Marginal default values provide a full and unique allocation of risk capital. Efficient capital allocations maintain credit quality and preclude risk shifting. Our theory leads to an adjusted present value (APV) criterion for making investment and contracting decisions. We set out implications for risk management and corporate finance.

Keywords: Capital allocation; Cash capital; Investment decisions; VaR; RAROC (search for similar items in EconPapers)
JEL-codes: G21 G22 G23 G28 G31 G32 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (18)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:118:y:2015:i:3:p:620-635

DOI: 10.1016/j.jfineco.2014.10.006

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