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Risk-Adjusted Return on Capital (RAROC)

Risk-Adjusted Return on Capital (RAROC) is a financial metric used to assess the profitability of an investment or business activity while accounting for the risk involved.It is calculated by dividing the expected return by the capital at risk and adjusting for potential losses. RAROC helps organizations evaluate the performance of their investments or projects in relation to the amount of risk they are taking. It is often used by financial institutions to allocate capital efficiently across different business units or investment opportunities.

Example

A bank calculates RAROC for two investment projects, choosing the one with the higher RAROC as it offers a better return relative to the risk taken.

Key points

• A metric that assesses profitability while adjusting for risk.

• Calculated as the expected return divided by the capital at risk.

• Helps organizations evaluate and compare investments or projects based on risk-adjusted performance.

Quick Answers to Curious Questions

It helps allocate capital efficiently by comparing the risk-adjusted returns of different investments or projects.

RAROC accounts for the risk involved, offering a more accurate measure of performance than traditional return metrics that do not consider risk.

Factors include the expected return, the amount of capital at risk, and the potential for losses based on risk scenarios.

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