Risk adjusted return on capital
Encyclopedia
Risk adjusted return on capital (RAROC) is a risk
-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability
across business
es. The concept was developed by Bankers Trust
and principal designer Dan Borge in the late 1970s. Note, however, that more and more Return on risk Adjusted Capital (RORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee
, currently Basel III
.
Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio
of risk adjusted return to economic capital
. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, it is a buffer against expected shocks in market values. Economic capital is a function of market risk
, credit risk
, and operational risk
, and is often calculated by VaR
. This use of capital based on risk improves the capital allocation across different functional areas of bank
s, insurance
companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.
RAROC system allocates capital for 2 basic reasons:
For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure
—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added
of each unit.
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
across business
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
es. The concept was developed by Bankers Trust
Bankers Trust
Bankers Trust was an historic American banking organization. The bank merged with Alex. Brown & Sons before being acquired by Deutsche Bank in 1998.-History:A consortium of banks created Bankers Trust to perform trust company services for their clients....
and principal designer Dan Borge in the late 1970s. Note, however, that more and more Return on risk Adjusted Capital (RORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...
, currently Basel III
Basel III
BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed upon by the members of the Basel Committee on Banking Supervision. The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial...
.
Basic formula
- RAROC = (Expected Return)/(Economic CapitalEconomic capital-Finance and Economics:In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation....
) or - RAROC = (Expected Return)/(Value at riskValue at riskIn financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
)
Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio
Ratio
In mathematics, a ratio is a relationship between two numbers of the same kind , usually expressed as "a to b" or a:b, sometimes expressed arithmetically as a dimensionless quotient of the two which explicitly indicates how many times the first number contains the second In mathematics, a ratio is...
of risk adjusted return to economic capital
Economic capital
-Finance and Economics:In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation....
. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, it is a buffer against expected shocks in market values. Economic capital is a function of market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
, credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
, and operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
, and is often calculated by VaR
Var
Var, VAR, VAr, VaR or var can mean:VAR* Varna Airport IATA airport code* Vacuum arc remelting, a process for production of steel and special alloys...
. This use of capital based on risk improves the capital allocation across different functional areas of bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s, insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.
RAROC system allocates capital for 2 basic reasons:
- Risk management
- Performance evaluation
For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added
Economic value added
In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
of each unit.
See also
- Enterprise risk managementEnterprise Risk ManagementEnterprise risk management in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives...
- Financial risk managementFinancial risk managementFinancial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...
- Risk-reward spectrum
- Sharpe ratioSharpe ratioThe Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk , named after William Forsyth Sharpe...
- Sortino ratioSortino ratioThe Sortino ratio measures the risk-adjusted return of an investment asset, portfolio or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target, or required rate of return, while the Sharpe ratio penalizes both upside and downside...