Return On Risk-Adjusted Capital (RAROC) Overview

Return on Risk-Adjusted Capital (RAROC) is a key financial metric employed

to assess the expected returns of an investment, accounting for the inherent risk.
This metric aids in understanding the profitability of various business ventures
or investments in relation to their associated risk.
The calculation of RAROC enables more informed decisions concerning capital
allocation and risk management.
Given that risk—defined as the potential for loss or subpar returns due to
unforeseen events—is an inherent part of any capital investment, RAROC provides
a comprehensive way to evaluate and manage these risks, ensuring optimal returns.
Investors, managers, and financial analysts widely use this tool for risk evaluation
and return optimization.

Key Components of RAROC

Expected Return
The expected return is a crucial component of the RAROC metric. This is an
estimation of the earnings or losses an investment is anticipated to generate over a
given period.

It is typically based on historical data or statistical models and forms the

foundation for the calculation of RAROC.

By integrating expected return into its calculation, RAROC takes into account
potential profits while also considering the associated risk.

Risk Measures
Risk measures are another essential element of RAROC. These measures may
include the standard deviation of returns (a common measure of investment risk),
value at risk (VaR), or expected shortfall.
Each risk measure provides a different perspective on the potential for loss and the
volatility of an investment.

Incorporating these risk measures into RAROC gives a holistic view of the
uncertainty associated with the investment. It quantifies the risk in concrete terms,
thus allowing investors to make more informed decisions.

Amount of Economic Capital

The amount of economic capital used in the investment is the final key component
of RAROC. Economic capital represents the amount of risk capital held by a
company, defined as capital that a firm allocates to cover potential losses.

By considering the amount of economic capital, RAROC offers a complete view of

the risk versus return trade-off. This component helps determine the efficiency of
the capital allocation, providing an assessment of the potential return in relation to
the risk taken.

By integrating these key components—expected return, risk measures, and the

amount of economic capital—RAROC provides a comprehensive and realistic
evaluation of the return on an investment or a business line, factoring in the
inherent risk
RAROC is calculated using the following formula:

RAROC = Revenue – Cost – Expected Losses / Economic Capital

Detailed Breakdown of Each Component of the RAROC Formula

Revenues: The total amount of money a business unit generates.

Costs: All the expenses incurred by the business unit. This could include operating
expenses, financing costs, and any other costs associated with running the unit.

Expected Losses: These are the losses that the financial institution expects to incur
due to risks like credit risk, market risk, operational risk, etc. These losses are often
estimated using statistical methods and models.

Economic Capital: This is the amount of risk capital that a bank estimates it needs
to cover potential losses over a certain time period at a given confidence level. It's
designed to absorb severe unexpected losses.

Almera Bank business unit has the following figures:

Revenues: $1,000,000
Costs: $300,000
Expected Losses: $100,000
Economic Capital: $2,000,000

The RAROC calculation starts by subtracting costs ($300,000) and expected losses
($100,000) from the revenues ($1,000,000), which yields $600,000.
Next, the result is divided by the Economic Capital. This gives 0.3 or 30%. This
RAROC of 30% indicates that for each dollar of risk-based capital employed, the
unit generates 30 cents of risk-adjusted profit.

Applications of RAROC in Finance

Banking
Banks use RAROC as a primary tool for risk management and capital allocation.
It helps banks to optimize their capital structure and to allocate resources
efficiently among different business lines.

Portfolio Management
In the field of portfolio management, RAROC serves as a key indicator of the risk-
adjusted performance of various assets in a portfolio. It assists portfolio managers
in making more informed investment decisions by considering both the expected
return and the associated risk.

Capital Budgeting
In capital budgeting, RAROC is used to evaluate the risk-adjusted profitability of
various investment projects. It helps businesses to prioritize and select projects
based on their risk-adjusted returns.