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The Dynamics of Capital Allocation

Financial institutions are facing increased pressure to enhance shareholder value. This has lead to the popularity of practical techniques such as EVA and RAROC. The major purpose of this study is to illustrate the interaction between incentive-based compensation and performance evaluation in a multiperiod setting. We demonstrate that while EVA can justifiably be used to incentivize managers to make better current investment decisions, performance measurement techniques such as RAROC help the firm to better assess abilities for the future. The model is applied to understand why hard position limits are employed as well as softer incentive contracts and what sort of termination standard should be used for the investment manager.