Risk adjusted return on capital
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Risk-Adjusted Return On Capital - RAROC
An adjustment to the return on an investment that accounts for the element of risk. Risk-adjusted return on capital (RAROC) gives decision makers the ability to compare the returns on several different projects with varying risk levels. RAROC was popularized by Bankers Trust in the 1980s as an adjustment to simple return on capital (ROC).
Income from capital = (capital charges)*(risk-free rate)
Expected loss = average anticipated loss over the measurement period
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In financial analysis, riskier projects and investments must be evaluated differently from their riskless counterparts. By discounting risky cash flows against less risky cash flows, RAROC accounts for changes in the profile of the investment. In general, the higher the risk, the higher the return. Thus, when companies need to compare and contrast two different projects or investments, it is important to take into account these possibilities.
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Risk adjusted return on capital
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Risk adjusted return on capital
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This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (July 2006) |
Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust and principal designer Dan Borge in the late 1970s.[1] Note, however, that more and more Return on risk Adjusted Capital (RORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel III.
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Basic formula
- RAROC = (Expected Return)/(Economic Capital)[2] or
- RAROC = (Expected Return)/(Value at risk)[2]
Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, it is a buffer against expected shocks in market values. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.
RAROC system allocates capital for 2 basic reasons:
- Risk management
- Performance evaluation
For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.
See also
- Enterprise risk management
- Financial risk management
- Risk-reward spectrum
- Sharpe ratio
- Sortino ratio
References
- ^ Herring, Richard; Diebold, Francis X.; Doherty, Neil A. (2010). The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice. Princeton, N.J: Princeton University Press. p. 347.
- ^ a b Quantifying Risk in the Electricity Business: A RAROC-based Approach
- "An Introduction to Broad Based Credit Engineering" By Morton Glantz
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