Risk-Adjusted Return on Capital (RAROC) Explained & Formula

What Is Risk-Adjusted Return On Capital (RAROC)?

Risk-adjusted return on capital (RAROC) is a modified return on investment (ROI) figure that takes elements of risk into account. In financial analysis, projects and investments with greater risk levels must be evaluated differently; RAROC thus accounts for changes in an investment’s profile by discounting risky cash flows against less-risky cash flows.

Key Takeaways

  • Risk-adjusted return on capital (RAROC) is a risk-adjusted measure of the return on investment.
  • It does this by accounting for any expected losses and income generated by capital, with the assumption that riskier projects should be accompanied by higher expected returns
  • RAROC is most often used by banks and other financial sector companies.

The Formula For RAROC Is

 R A R O C = r e e l + i f c c where: RAROC = Risk-adjusted return on capital r = Revenue e = Expenses e l = Expected loss which equals average loss e l = expected over a specified period of time i f c = Income from capital which equals i f c = (capital charges) × (the risk-free rate) \begin{aligned}&RAROC=\frac{r-e-el+ifc}{c}\\&\textbf{where:}\\&\text{RAROC}=\text{Risk-adjusted return on capital}\\&r=\text{Revenue}\\&e=\text{Expenses}\\&el=\text{Expected loss which equals average loss}\\&\phantom{el=}\text{expected over a specified period of time}\\&ifc=\text{Income from capital which equals}\\&\phantom{ifc=}\text{(capital charges)}\times{\text{(the risk-free rate)}}\\&c=\text{Capital}\end{aligned} RAROC=creel+ifcwhere:RAROC=Risk-adjusted return on capitalr=Revenuee=Expensesel=Expected loss which equals average lossel=expected over a specified period of timeifc=Income from capital which equalsifc=(capital charges)×(the risk-free rate)

Understanding Risk-Adjusted Return On Capital

Risk-adjusted return on capital is a useful tool in assessing potential acquisitions. The general underlying assumption of RAROC is investments or projects with higher levels of risk offer substantially higher returns. Companies that need to compare two or more different projects or investments must keep this in mind.

RAROC and Bankers Trust

RAROC is also referred to as a profitability-measurement framework, based on risk, that allows analysts to examine a company’s financial performance and establish a steady view of profitability across business sectors and industries.

The RAROC metric was developed during the late 1970s by Bankers Trust, more specifically Dan Borge, its principal designer. The tool grew in popularity through the 1980s, serving as a newly developed adjustment to simple return on capital (ROC). A commercial bank at the time, Bankers Trust adopted a business model similar to that of an investment bank. Bankers Trust had unloaded its retail lending and deposit businesses and dealt actively in exempt securities, with a derivative business beginning to take root.

These wholesale activities facilitated the development of the RAROC model. Nationwide publicity led a number of other banks to develop their own RAROC systems. The banks gave their systems different names, essentially lingo used to indicate the same type of metric. Other methods include return on risk-adjusted capital (RORAC) and risk-adjusted return on risk-adjusted capital (RARORAC). The most commonly used is still RAROC. Non-banking firms utilize RAROC as a metric for the effect that operational, market and credit risk have on finances.

Return on Risk-Adjusted Capital

Not to be confused with RAROC, the return on risk-adjusted capital (RORAC) is used in financial analysis to calculate a rate of return, where projects and investments with higher levels of risk are evaluated based on the amount of capital at risk. More and more, companies are using RORAC as a greater amount of emphasis is placed on risk management throughout a company. The calculation for this metric is similar to RAROC, with the major difference being capital is adjusted for risk with RAROC instead of the rate of return.

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