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
RAROC=cr−e−el+ifcwhere:RAROC=Risk-adjustedreturnoncapitalr=Revenuee=Expensesel=Expectedlosswhichequalsaveragelossel=expectedoveraspecifiedperiodoftimeifc=Incomefromcapitalwhichequalsifc=(capitalcharges)×(therisk-freerate)
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.
How Can You Determine the Expected Loss From Capital?
Calculating RAROC requires knowing the expected loss from an investment. To find this number, you'll need to estimate the odds of failure or default and multiply that by the loss that you'd experience in the event of that failure.
What Are Other Methods of Assessing Risk and Return?
There are many tools that investors and business analysts can use to assess the risk and return of potential investments. For example, investors may look at the Sharpe ratio of an investment, which compares the return of an investment and its standard deviation from that return to the risk-free rate of return.
Are There Drawbacks to Using Risk-Adjusted Return on Capital?
Yes, risk-adjusted return on capital is an imperfect measure and there are drawbacks to using it. One drawback is that calculating it can be difficult and require a lot of data because you need to estimate potential losses. An overreliance on RAROC can also lead to bad decisions. An investment with a high RAROC can still be a poor choice of the risk of failure is incredibly high.
How Does Risk-Adjusted Return on Capital Differ from Other Return on Investment Measures?
RAROC differs from other methods of determining the return on investment because it considers the risks involved. If you can double your money by predicting the outcome of a coin flip or lose it for being incorrect, the ROI on a successful flip is 100%, but the RAROC would only be 50% because of the expected loss involved. This means RAROC offers a more thorough understanding of an investment's potential returns.
The Bottom Line
Risk-adjusted return on capital offers financial analysts a method for determining the best way to allocate funds, accounting for the risk of different investments or acquisitions. Generally, opportunities with a higher RAROC are better because they tend to offer greater returns in the long run, even if there is a risk of failure or loss. Being able to calculate RAROC is helpful for investors and business owners who want to determine the best way to use their limited capital.
FAQs
The formula for RAROC is revenue minus costs minus expected loss dividend by economic capital. Expected loss is calculated by multiplying the probability default, loss given default, and exposure at default together. The higher the probability of default, the higher the risk of the loan portfolio.
How do you calculate risk-adjusted return? ›
Risk-Adjusted Return Calculation Example
The Sharpe Ratio measures the excess return per unit of total risk, which we'll calculate by subtracting the risk-free rate from the portfolio return and then dividing by the portfolio's standard deviation.
How do you calculate return on risk capital? ›
RORAC is dividing net income by risk-weighted assets (RWA). RWA are already weighted by their level of risk so using as the denominator provides a ready-made risk ratio that can be used to compare like-for-like across different businesses.
What is the formula for risk-adjusted capital? ›
What Is the Risk-Adjusted Capital Ratio? The risk-adjusted capital ratio is used to gauge a financial institution's ability to continue functioning in the event of an economic downturn. It is calculated by dividing a financial institution's total adjusted capital by its risk-weighted assets (RWA).
What is the difference between Roe and RAROC? ›
The RORAC is similar to return on equity (ROE), except the denominator is adjusted to account for the risk of a project.
How is RAROC calculated? ›
The risk-adjusted return on capital is calculated as follows: Risk-adjusted return on capital = (Revenues - costs - expected losses) / Economic capital.
What is a good risk adjusted return on capital? ›
Most regulators require a minimum ratio between 8-10.5%. Higher ratios indicate a bank is better capitalized to absorb potential losses. The risk-adjusted capital ratio is a critical regulatory metric for assessing a bank's financial health and stability.
What is an example of return on capital calculation? ›
For example, if a company's profit equals $10 million for a period, and the total value of the shareholders' equity interests in the company equals $100 million, and debts equal $100 million, the return on capital equals 5% ($10 million divided by $200 million).
What is the risk-adjusted return model? ›
A risk-adjusted return measures an investment's return after considering the degree of risk taken to achieve it. There are several methods for evaluating risk-adjusting performance, such as the Sharpe and Treynor ratios, alpha, beta, and standard deviation, with each yielding a slightly different result.
What is the formula for risk-adjusted return on capital on a loan? ›
RAROC (Risk-adjusted return on capital)
Determines the return on investment by adjusting all the associated risks. It expresses risk-adjusted returns as a percentage of economic capital. Formula: RAROC = {Expected revenue – (Operating cost + Interest charges) + Return on capital – Expected losses}/Economic capital.
Definition. The risk-adjusted rate on capital is a financial metric that adjusts the profitability of an investment by its expected risk. Risk-adjusted return on capital (RAROC) is a modified return on investment (ROI) figure that takes elements of risk into account.
Why is risk-adjusted return important? ›
Risk-adjusted returns offer a metric that can provide a more accurate picture of an investment's true performance and allows investors to assess whether the return they are receiving adequately compensates them for the level of risk they are taking on.
What is RAROC for loan pricing? ›
A best practice approach assesses risk using risk-adjusted return on capital (RAROC), a metric defined by net income — comprised of interest income, interest expense, funds transfer pricing, and more — divided by the risk-adjusted capital assigned to each portfolio (Figure 1).
How to improve RAROC? ›
Represent the RAROC ratio objective in the form of a difference of the proportional change in the numerator and denominator. 3. Calculate derivatives of the numerator and denominator with respect to individuals positions. Use that as the incremental change basis for maximum ascent search path.
What is the difference between RAROC and RWA? ›
Risk-Weighted Assets (RWA) serve as the foundation for calculating RAROC. RWAs represent the total amount of capital that a financial institution must hold to cover its credit, market, and operational risks. These risks are weighted based on their perceived riskiness, with higher weights assigned to riskier exposures.
Is ROE or ROIC more important? ›
Each one tells you something a bit different, but in our view, ROIC is the most useful all-around metric because it reflects all the investors in the company – not just the equity investors (common shareholders).
How is risk adjustment calculated? ›
The risk Score formula is equal to the sum of the demographic factors and the disease factors. The sum of those factors equals the raw risk score. CMS then applies several methodological adjustments to the raw risk score.
What is the formula for the adjusted rate of return? ›
Inflation-adjusted return = (1 + Stock Return) / (1 + Inflation) - 1 = (1.233 / 1.03) - 1 = 19.7 percent.
What is the formula for risk adjusted cost? ›
The simple approach to this risk adjustment is to calculate the value to be added by multiplying the probability of a certain additional cost by its financial impact.
