Risk-Adjusted Return on Capital
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.
Risk-Adjusted Return on Capital (RAROC)
Risk-Adjusted Return on Capital (RAROC) is a modified metric of Return on Investment (ROI) that takes risk factors into account. In financial analysis, projects and investments with higher risk levels must be evaluated differently; thus, RAROC adjusts for high-risk cash flows by discounting them relative to low-risk cash flows.
Definition
Risk-Adjusted Return on Capital (RAROC) is a metric that measures the return on investment while considering the risk factors involved. The formula for calculating RAROC is:
RAROC = (Risk-Adjusted Return) / (Economic Capital).
Origin
The concept of RAROC was first introduced by banks and financial institutions in the 1980s to more accurately assess and manage risk. As financial markets became more complex, traditional ROI could no longer meet the needs for evaluating high-risk investments, leading to the development of RAROC.
Categories and Characteristics
RAROC can be divided into the following categories:
- Economic Capital RAROC: Based on economic capital, mainly used by banks and financial institutions.
- Market Risk RAROC: Considers the impact of market volatility on investment returns.
- Credit Risk RAROC: Assesses the impact of borrower default risk on investment returns.
Characteristics:
- Considers risk factors, making return assessments more accurate.
- Helps optimize capital allocation and improve investment decision-making.
- Suitable for evaluating high-risk investment projects.
Specific Cases
Case 1: A bank is evaluating two loan projects. Project A has an expected return of 1 million yuan but is high-risk; Project B has an expected return of 800,000 yuan and is low-risk. Through RAROC calculation, Project A's RAROC is 10%, and Project B's RAROC is 12%. Despite Project A's higher expected return, the bank ultimately chooses Project B due to its higher risk-adjusted return.
Case 2: An investment company is evaluating a high-risk stock portfolio. Through RAROC calculation, it finds that the portfolio's risk-adjusted return is 8%, below the company's minimum required return of 10%. Therefore, the company decides not to proceed with the investment.
Common Questions
1. Why is RAROC more important than traditional ROI?
Because RAROC considers risk factors, making return assessments more accurate, especially for high-risk investment projects.
2. How is RAROC calculated?
RAROC = (Risk-Adjusted Return) / (Economic Capital).
3. What are the main application scenarios for RAROC?
Mainly used for risk management and capital allocation decisions in banks and financial institutions.
