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. The formula used to calculate RAROC is:

Risk Adjusted Return on Capital (RAROC)

Where:

Income from capital = (capital charges) x (risk-free rate)

Expected loss = average loss expected over a specified period of time

In financial analysis, projects and investments with greater risk levels must be evaluated differently; RAROC accounts for changes in an investment’s profile by discounting risky cash flows against less-risky cash flows.

BREAKING DOWN 'Risk-Adjusted Return On Capital - RAROC'

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 names include return on risk-adjusted capital (RORAC) and risk-adjusted return on risk-adjusted capital (RARORAC). The most commonly used present term for the metric is still RAROC. Nonbanking firms utilize RAROC as a metric for the effect that operational, market and credit risk has on finances.

Return on Risk-Adjusted Capital

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 highly similar to RAROC, with the major difference being capital is adjusted for risk with RAROC instead of the rate of return.

RELATED TERMS
  1. Risk-Adjusted Return

    A risk-adjusted return takes into account the amount of risk ...
  2. Information Ratio (IR)

    The information ratio is a ratio of portfolio returns beyond ...
  3. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the ...
  4. Market Risk Premium

    Market risk premium is the difference between the expected return ...
  5. Annual Return

    Annual return is the compound average rate of return for a stock, ...
  6. Bankers' Bank

    A bankers' bank is a specific type of bank that a group of larger, ...
Related Articles
  1. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  2. Investing

    Using Economic Capital To Determine Risk

    Discover how banks and financial institutions use economic capital to enhance risk management.
  3. Investing

    5 Ways to Rate Your Portfolio Manager

    These five performance ratios will help you measure how good your money manager is at increasing the value of your portfolio.
  4. Investing

    Understanding Quantitative Analysis Of Hedge Funds

    Learn how hedge fund performance quantitatively requires metrics such as absolute and relative returns, risk measurement, and benchmark performance ratios.
  5. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  6. Investing

    8 Stocks Poised To Lead In An Uncertain Market

    Goldman Sachs has identified stocks that it forecasts will post the highest risk-adjusted returns.
  7. Investing

    3 Ways To Evaluate the Performance of Alternatives

    Learn about three ways to measure the performance of alternative investments. See how the commonly used Sharpe ratio has drawbacks in measuring volatility.
  8. Investing

    5 ways to measure mutual fund risk

    Statistical measures such as alpha and beta can help investors understand investment risk on mutual funds and how it relates to returns.
  9. Personal Finance

    Investment Banker: Job Description & Average Salary

    An investment banker job description which includes what they do in a typical work day, the skills needed to be successful and how they are paid.
RELATED FAQS
  1. What is the difference between a sharpe ratio and an information ratio?

    Understand the meaning of the Sharpe ratio and the information ratio, and understand how they differ as tools for evaluating ... Read Answer >>
  2. What is the difference between the Sharpe ratio and alpha?

    Use alpha and the Sharpe ratio to evaluate mutual funds by comparing their risk-adjusted returns. Learn what modern portfolio ... Read Answer >>
  3. Use market risk premium for expected market return

    Find out how the expected market return rate is determined when calculating market risk premium – and how to estimate investment ... Read Answer >>
  4. How does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
  5. What is the difference between cost of equity and cost of capital?

    Cost of equity is the percentage return demanded by a company's owners; the cost of capital includes the rate of return demanded ... Read Answer >>
Trading Center