RAROC
Refers to the risk Adjusted return on capital.
RAROC methodology is one apporach to relate the return on capital to the riskiness of the investment. Thus, it is likely to prove a critical component of any integrated risk management famework. Indeed, one can think of RAROC analysis as the glue that binds a firm's risk management and business activities together.
To illustrate the RAROC calculation, let us assume the following: A loan portfolio with a principal of usd 1 bn is considered, paying an annual rate of 9 percent. The economic capital against such a loan is estimated to be usd 75 m (i.e. 7,5% of the loan). Therefore, usd 1 bn should be raised by deposits with an interest chrage of 6%, and usd 75 m should be added in equity capital to be invested in Government securities returning 6,5 percent per annum. The bank in this example has an operating cost of usd 15 m per annum, and the expected loss on this portfolio is assumed to be 1 percent per annum (i.e. usd 10 m). The RAROC for this loan is thus:
RAROC = (90+4.9-60-15-10) / 75 = 13.2% |
Similar financial terms
Risk-adjusted return on capital (RAROC)
Measures performance on a risk-adjusted basis. Calculated as the economic return divided by economic capital. RAROC helps determine if a company has the right balance between capital, returns and risk. The central concept in RAROC is economic capital: the amount of capital a company should put aside needed based on the risk it runs.
