RAROC

Risk adjusted return on capital, or RAROC, is one of the most commonly used risk vs. reward evaluation tools in the investment world. Initially developed at Bankers Trust in the 1970s, RAROC allows investors to compare investments with disparate risk factors by providing a method for calculating the effect of those risks on the expected return on investment.

RAROC definition


RAROC is defined as a ratio used to determine risk adjusted return on capital. Specifically, RAROC compares the amount of economic capital needed to secure a certain investment with the likely return on the initial investment, adjusted to reflect the degree of risk involved in the financial endeavor. This allows a more accurate calculation of the probable risk-reward scenarios and provides a useful method of comparing two or more different investment options that present varying levels of risk. RAROC figures are also used to evaluate the past performance of companies; this too can provide valuable information to investment analysts regarding likely future performance.

RAROC calculation


While different companies may use slightly different figures in determining the risk adjusted return on capital for investments, RAROC calculation generally is achieved by subtracting current operating expenses including any taxes to be paid and expected losses from the sum of current revenue and income derived from capital and dividing the resulting amount by the amount of economic capital the company maintains. Income derived from capital is calculated by multiplying the company’s capital charges by the risk-free rate, while expected losses are averaged over the entire period to be analyzed.

While some variations exist, the standard formula for RAROC calculation is as follows:

RAROC = (revenue + income derived from capital – operating expenses – expected losses) / economic capital

RAROC applications


RAROC is used by lenders and investment analysts to determine the credit risk of differing investments. A classic RAROC example is that of a start-up company that assumes high risks and is expected to sustain significant financial losses, but shows high revenue potential as well. When compared with a more stable investment, the initial evaluation of potential profit may come down heavily on the side of the riskier proposition; however, by using RAROC a more accurate comparison between these two disparate types of investments can be made.

RAROC Complications


Not all lending companies use the precise formula outlined in the above RAROC example. Some incorporate capital diversification advantages as part of the overall capital benefits and include it in the revenue stream; this can lead to seriously skewed results and result in financial institutions overextending themselves in the high-risk marketplace. Additionally, many companies are turning to return on risk adjusted capital calculations (RORAC) as a more reliable measure of overall risk than RAROC, due to the higher value RORAC calculations place on risk versus reward.

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Tim Ord
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