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RAROC is a risk based profitability measurement for analyzing the risk-adjusted financial performance of the company and for providing a consistent view of the profitability across businesses. RAROC is usually used in banking parlance where companies have to handle the risk of losses.
In business enterprises, risk is traded off against benefits. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is required to secure the survival of the organization in a worst case scenario; it is a buffer against expected shocks in the market values. Economic capital is a function of credit risk, market risk and operational risk and is often calculated by VaR (Value at Risk). This use of capital based on risk improves the capital allocation across the different functional areas of banks, insurance companies or any other business in which capital is placed at risk for an expected return above the risk-free rate.
Formula:
RAROC = Expected Return / Economic Capital or
RAROC = Expected Return / Value at Risk
What else can I help you with?
Explain the function of the capital market in economic development?
allows investors to get more capital for investment and can reduce government tax - Trading for more than one year - Low,medium,high quality of securities - Secondary - Have debt and equity both - High risk, high return
What is capital allocation line?
The capital allocation line (CAL) represents the risk-return trade-off of a portfolio that combines a risk-free asset and a risky asset or portfolio of assets. It is a graphical line that shows the expected return of a portfolio against its risk, measured by standard deviation. The slope of the CAL indicates the risk premium per unit of risk, helping investors determine the optimal mix of risk-free and risky investments to achieve their desired return. The point where the CAL is tangent to the efficient frontier represents the optimal risky portfolio.
How can one determine the expected rate of return for an investment?
To determine the expected rate of return for an investment, one can calculate the average annual return based on historical data, analyze the current market conditions and economic outlook, consider the risk associated with the investment, and use financial models such as the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM).
What factors do economists consider to be economic resources?
Generally, economic resource (reward): Land (rent); Labour (wages); Capital (interest); Entrepreneurship (profit). Combined with management and economic risk taking and specific needs of the market give output.
What is risk return relationship?
The risk return relationship is a business concept referring to the risk involved in exchange for the amount of return gained on an investment. These two factors are directly proportional to each other, meaning the more return sought, the higher the risk that is undertaken.
How do you compute the risk-adjusted return on an investment?
The risk-adjusted return is a measure of how much risk a fund or portfolio takes on to earn its returns, usually expressed as a number or a rating. This is often represented by the Sharpe Ratio. The more return per unit of risk, the better. The Sharpe Ratio is calculated as the difference between the mean portfolio return and the risk free rate (numerator) divided by the standard deviation of portfolio returns (denominator).
Suppose a firm estimates its cost of capital for the coming year to be 10 What are the reasonable cost of capital for an average risk project high risk and low risk?
In order to determine reasonable costs of capital for average, high and low risk projects the firm should develop risk-adjusted costs of capital for each category of risk based on the concept of divisional WACC. If a firm estimates that its cost of capital for the coming year will be 10%, the firm should use 10% as the basis for its average risk projects since the firm will need to achieve a minimum of a 10% return on all its projects. Typically, a high-risk project has the potential for higher returns and a low-risk project will typically yield lower returns. Therefore, the firm could set the cost of capital for its high-risk projects at 12% and the cost of capital for low risk projects at 8%. Since the average risk project has a 10% cost of capital, the overall risk of the firms projects will be equal to the 10% cost of capital. Similarly, if the firm's high-risk projects are particularly risky, they could be set at a 15% cost of capital and the low-risk projects will be adjusted down to a 5% cost of capital. The ultimate goal is that the portfolio of the firm's projects will achieve the required 10% return or greater so that the cost of capital to fund the projects is covered. The assignment of risk is somewhat subjective but it is better than not adjusting the risk at all.
Why is WACC a more appropriate discount rate when doing capital budgeting?
WACC (Weighted Average Cost of Capital) is a more appropriate discount rate for capital budgeting because it reflects the overall cost of financing a project. It considers both the cost of debt and the cost of equity, taking into account the proportion of each in the capital structure. By using WACC as the discount rate, the project's cash flows are appropriately risk-adjusted and it helps in determining the economic viability of the investment.
What does the tangency point M represent in the Capital Market Line?
The tangency point M represents one main feature and factor in the Capital market Line which is called the market portfolio which shows the wealth which is in a risky position in the assets of a company.
What is capital risk?
Capital risk refers to the potential loss of funds invested in a financial asset or business venture. It encompasses the possibility that the value of an investment may decline, leading to a reduction in the original capital. This risk is particularly relevant for investors and companies, as it can impact their financial stability and return on investment. Effective risk management strategies are essential to mitigate capital risk.
What typically is used to calculate the opportunity cost of capital on a risk-free investment?
The opportunity cost of capital for a risk-free investment is typically calculated using the return on a benchmark risk-free asset, such as government treasury bonds or bills. This rate reflects the compensation investors would expect for forgoing other investment opportunities with similar risk levels. Additionally, the risk-free rate can be adjusted for inflation to determine the real opportunity cost. Ultimately, it serves as a baseline to evaluate the potential returns of other investments.
What are the similarities and differences between the risk-adjusted discount rate and the certainty equivalent methods for incorporating risk into the capital-budgeting?
The primary difference between the certainty equivalent approach and the risk-adjusted discount rate approach is where the adjustment for risk is incorporated into the calculations. The certainty equivalent approach penalizes or adjusts downwards the value of the expected annual free cash flows, while the risk-adjusted discount rate leaves the cash flows at their expected value and adjusts the required rate of return, k, upwards to compensate for added risk. In either case the net present value of the project is being adjusted downwards to compensate for additional risk. An additional difference between these methods is that the risk-adjusted discount rate assumes that risk increases over time and that cash flows occurring later in the future should be more severely penalized. The certainty equivalent method, on the other hand, allows each cash flow to be treated individually.
Why CML is a special case of SML?
CML a special case of SML. While CML represents Return potential and risk involved in all financial asset across the Capital market, SML is the linear relationship between the expected return of security and its systematic risk, the expected return comparing a risk-free return plus a risk premium.
What is the Capital Asset pricing model used for?
The Capital Asset Pricing Model is a pricing model that describes the relationship between expected return and risk. The CAPM helps determine if investments are worth the risk.
Explain the function of the capital market in economic development?
allows investors to get more capital for investment and can reduce government tax - Trading for more than one year - Low,medium,high quality of securities - Secondary - Have debt and equity both - High risk, high return
Is the cost of capital for each source of funds is a cost dependent on current market conditions and expected reates of return?
Yes, the cost of capital for each source of funds is indeed dependent on current market conditions and expected rates of return. Market interest rates, investor risk perceptions, and overall economic conditions can affect the cost of debt, equity, and other financing sources. Additionally, expected returns on investments influence how much investors demand in compensation for their risk, thereby impacting the overall cost of capital for a business.
What is Capital Asset Pricing Model CAPM?
The Capital Asset Pricing Model (CAPM) is a financial model that establishes a relationship between the expected return of an asset and its systematic risk, measured by beta. It suggests that the expected return on an investment is equal to the risk-free rate plus a risk premium, which is proportional to the asset's beta and the market risk premium. CAPM is widely used in finance for asset pricing and portfolio management, helping investors assess the potential return of an investment relative to its risk.
