Risk-Adjusted Return on Capital (RAROC)
Risk-Adjusted Return on Capital (RAROC) is a financial metric used by banks, investment firms, and corporations to measure the return on investment adjusted for the risk taken.
RAROC is a tool for evaluating the performance of an investment portfolio, a business unit, or an entire firm by considering both the returns it generates and the risk it entails.
Key Takeaways – RAROC
- RAROC = Expected Return / Economic Capital
- RAROC is a risk-based profitability measurement framework for assessing risk-adjusted financial performance.
- It provides a consistent view of profitability across businesses by dividing the expected return by economic capital.
- It helps in making informed decisions by pricing risk and evaluating the capital efficiency of revenue-generating activities.
- We look at RAROC’s value for traditional traders.
How RAROC Works
Divide expected return by economic capital adjusted for risk.
RAROC calculation begins by assessing the expected return of an investment.
Then, it adjusts this return by the economic capital.
This is the amount of capital that an entity needs to cover potential losses from an investment – based on the risk it carries.
This provides a clear picture of how much profit an investment is generating vis-a-vis the amount of risk capital that has been put at stake.
Components of RAROC
There are two critical components of RAROC:
- Expected Return: This is the profit that an entity expects to earn from an investment.
- Economic Capital: This is the amount of capital required to absorb possible losses, a measure of the risk of an investment.
Example of RAROC
Let’s say a bank invests in a loan that is expected to return $120,000, and the economic capital required for the loan, considering the risk, is $1,000,000.
To calculate the RAROC, you would divide the expected return by the economic capital:
RAROC = Expected Return / Economic Capital
RAROC = $120,000 / $1,000,000 = 0.12 or 12%
This means the RAROC for the loan is 12%.
Application of RAROC
Banks and Financial Institutions
Banks use RAROC to determine the profitability of their loans and investments.
It considers the creditworthiness of borrowers and the risk of default.
It allows them to price their products in a way that is commensurate with the risk involved.
Portfolio managers apply RAROC to allocate assets effectively.
By measuring the return against risk capital, they can decide which investments might yield the best risk-adjusted returns – and help optimize the portfolio’s performance.
In corporations, RAROC is used to appraise projects and investment opportunities.
It helps in determining whether the potential returns from a project justify the risks and the capital allocated.
Advantages of RAROC
RAROC provides several benefits:
- Encourages Risk Awareness: By focusing on risk-adjusted returns, RAROC emphasizes risk awareness and management.
- Supports Strategic Planning: It aids in aligning business strategies with risk appetite and capital management.
- Enhances Performance Measurement: RAROC enables a fair assessment of performance across different business units with varying risk profiles.
- Improves Capital Allocation: It helps in allocating capital to the highest yielding risk-adjusted opportunities.
Challenges with RAROC
Despite its advantages, RAROC has its set of challenges:
- Complexity: Determining the economic capital for different types of risk can be complex.
- Data Requirements: Accurate RAROC calculation requires high-quality data. This may not always be available.
- Subjectivity: There can be subjectivity in the models used for calculating RAROC. Can lead to inconsistencies.
RAROC vs. Other Metrics
Unlike ROI, which does not account for risk, RAROC provides a more comprehensive view by including risk in the equation.
ROE measures profitability from shareholders’ equity but does not specifically adjust for risk, which RAROC explicitly does.
RAROC for Traders
RAROC is also a useful metric for traditional traders.
Most novice traders do poorly by blowing out their risk.
So if they do make anything, they tend to not keep it for long.
It’s virtually impossible to have consistent success trading/investing without prudent risk controls.
Both maximizing return per unit of risk while keeping a portfolio within acceptable risk parameters is key.
RAROC is a tool for assessing the profitability of investments and business activities with an integrated view of risk.
It offers a framework for risk management and performance assessment.
But its effectiveness is dependent on the quality of risk measurement and the assumptions used in the economic capital calculation.