What is Risk-Adjusted Return on Capital (RAROC)?
Risk-adjusted return on capital (RAROC) is an advanced version of the traditional return on investment (ROI) that integrates elements of risk into the equation. In financial analysis, projects and investments that carry higher risks require different evaluation criteria. RAROC accounts for these variations by discounting risky cash flows compared to less risky ones.
Key Takeaways
- Risk-Adjusted Measure: RAROC evaluates return on investment while considering risk.
- Expected Loss Accounting: This metric factors in expected losses and income generated by capital, stressing that riskier projects should deliver higher expected returns.
- Frequent Usage: RAROC is predominantly used by banks and other financial institutions.
The Formula for RAROC
The fundamental formula for RAROC is as follows:
[ RAROC = \frac{r - e - el + ifc}{c} ]
Where:
- RAROC: Risk-adjusted return on capital
- r: Revenue
- e: Expenses
- el: Expected loss over a specified period
- ifc: Income from capital, calculated as capital charges times the risk-free rate
- c: Capital
Understanding Risk-Adjusted Return on Capital
RAROC is instrumental in evaluating potential acquisitions. The core principle of RAROC is that investments with higher risk levels should offer proportionally higher returns. This is essential for companies that need to compare various projects or investment options.
History and Evolution of RAROC
RAROC: A Breakthrough by Bankers Trust
RAROC also functions as a profitability measurement framework that integrates risk to ensure a standardized view of profitability across various industries. Developed during the late 1970s by Bankers Trust, specifically designed by Dan Borge, RAROC gained significant traction in the 1980s. Bankers Trust, a commercial bank functioning similarly to an investment bank, pioneered this model by divesting its retail lending and deposit businesses and focusing on derivatives and exempt securities.
This shift gave rise to the need for a dynamic profitability model, culminating in the widespread adoption of RAROC. Other banks developed similar systems under different names, but RAROC remained the benchmark metric. Non-banking firms have also embraced RAROC to measure the impact of operational, market, and credit risks on their financial health.
Understanding Return on Risk-Adjusted Capital (RORAC)
While similar, RORAC (Return on Risk-Adjusted Capital) should not be confused with RAROC. In financial analysis, RORAC calculates the rate of return by evaluating risk-based capital. With an increasing emphasis on risk management, companies are adopting RORAC, involving adjustments in capital rather than the rate of return used in RAROC.
Whether in banking or across other sectors, mastering RAROC can guide companies towards smarter, more risk-aware investment decisions.
Related Terms: return on investment, RORAC, financial analysis, risk management.
