Risk-adjusted return on capital (RAROC)

Similar financial terms

Risk-adjusted return
Return earned on an asset normalized for the amount of risk associated with that asset.

Risk-adjusted profitability
A probability used to determine a "sure" expected value (sometimes called a certainty equivalent) that would be equivalent to the actual risky expected value.

Abnormal return
In event studies, the part of the return that is not predicted; the change in value caused by the event. Also referred to as excess return, benchmark adjusted.

Total return swap
A total return swap is an exchange of a return on a debt security for LIBOR plus a spread. The return on the debt security includes income such as coupons and the change in its value.

Internal Rate of Return (IRR)
The internal rate of Return (IRR) is the discount rate that equals the present value of a future steam of cash flows to the initial investment. The IRR can be thought of as the annualized rate of return (in percent) of an investment using compound interest rate calculations. The IRR calculation is very useful when a number of future cash flows on which an interest rate needs to be calculated.

Abnormal returns
Part of the return that is not due to systematic influences (market wide influences). In other words, abnormal returns are above those predicted by the market movement alone.

After-tax real rate of return
Money after-tax rate of return minus the inflation rate.

Annualized holding period return
The annual rate of return that when compounded t times, would have given the same t-period holding return as actually occurred from period 1 to period t.

Unleveraged required return
The required return on an investment when the investment is financed entirely by equity (i.e. no debt).

Total return
In performance measurement, the actual rate of return realized over some evaluation period. In fixed income analysis, the potential return that considers all three sources of return (coupon interest, interest on interest, and any capital gain/loss) over some i nvestment horizon.

Total dollar return
The dollar return on a nondollar investment, which includes the sum of any dividend/interest income, capital gains or losses, and currency gains or losses on the investment. See also: total return.

T-period holding-period return
The percentage return over the T-year period an investment lasts.

Subperiod return
The return of a portfolio over a shorter period of time than the evaluation period.

Safety-net return
The minimum available return that will trigger an immunization strategy in a contingent immunization strategy.

Riskless rate of return
The rate earned on a riskless asset.

Return-to-maturity expectations
A variant of pure expectations theory which suggests that the return that an investor will realize by rolling over short-term bonds to some investment horizon will be the same as holding a zero-coupon bond with a maturity that is the same as that investment horizon.

Return on total assets
The ratio of earnings available to common stockholders to total assets.

Return on investment (ROI)
Generally, book income as a proportion of net book value.

Return on equity (ROE)
Indicator of profitability. Determined by dividing net income for the past 12 months by common stockholder equity (adjusted for stock splits). Result is shown as a percentage. Investors use ROE as a measure of how a company is using its money. ROE may be decomposed into return on assets (ROA) multiplied by financial leverage (total assets/total equity).

Return on assets (ROA)
Indicator of profitability. Determined by dividing net income for the past 12 months by total average assets. Result is shown as a percentage. ROA can be decomposed into return on sales (net income/sales) multiplied by asset utilization (sales/assets).

Return
The change in the value of a portfolio over an evaluation period, including any distributions made from the portfolio during that period.

Required return
The minimum expected return you would require to be willing to purchase the asset, that is, to make the investment.

Realized return
The return that is actually earned over a given time period.

Rate of return ratios
Ratios that are designed to measure the profitability of the firm in relation to various measures of the funds invested in the firm.

Portfolio internal rate of return
The rate of return computed by first determining the cash flows for all the bonds in the portfolio and then finding the interest rate that will make the present value of the cash flows equal to the market value of the portfolio.

Multiple rates of return
More than one rate of return from the same project that make the net present value of the project equal to zero. This situation arises when the IRR method is used for a project in which negative cash flows follow positive cash flows. For each sign change in the cash flows, there is a rate of return.

Money rate of return
Annual money return as a percentage of asset value.

Market return
The return on the market portfolio.

Leveraged required return
The required return on an investment when the investment is financed partially by debt.

Cumulative abnormal return (CAR)
Sum of the differences between the expected return on a stock and the actual return that comes from the release of news to the market.

Capital stock
The value of an outstanding share of stock at the time it was issued

Capitalization
The combined sources of capital, consisting of dept capital (liabilities) and equity capital (capital stock and retained earnings).

Working capital ratio
Working capital expressed as a percentage of sales.

Working capital management
The management of current assets and current liabilities to maximize short-term liquidity.

Working capital
Defined as the difference in current assets and current liabilities (excluding short-term debt). Current assets may or may not include cash and cash equivalents, depending on the company.

Weighted average cost of capital
The weighted average cost of capital (WACC) is the expected return on a portfolio of all the firm's securities when debt, equity and tax shields are taken into account. Used as a hurdle rate for capital investment.

Venture capital
An investment in a start-up business that is perceived to have excellent growth prospects but does not have access to capital markets. Type of financing sought by early-stage companies seeking to grow rapidly.

Static theory of capital structure
Theory that the firm's capital structure is determined by a trade-off of the value of tax shields against the costs of bankruptcy.

Soft Capital Rationing
Capital rationing that under certain circumstances can be violated or even viewed as made up of targets rather than absolute constraints.

Real capital
Wealth that can be represented in financial terms, such as savings account balances, financial securities, and real estate.

Pro forma capital structure analysis
A method of analyzing the impact of alternative capital structure choices on a firm's credit statistics and reported financial results, especially to determine whether the firm will be able to use projected tax shield benefits fully.

Planned capital expenditure program
Capital expenditure program as outlined in the corporate financial plan.

Pie model of capital structure
A model of the debt/equity ratio of the firms, graphically depicted in slices of a pie that represent the value of the firm in the capital markets.

Personal tax view (of capital structure)
The argument that the difference in personal tax rates between income from debt and income from equity eliminates the disadvantage from the double taxation (corporate and personal) of income from equity.

Perfect market view (of capital structure)
Analysis of a firm's capital structure decision, which shows the irrelevance of capital structure in a perfect capital market.

Perfect capital market
A market in which there are never any arbitrage opportunities.

Pecking-order view (of capital structure)
The argument that external financing transaction costs, especially those associated with the problem of adverse selection, create a dynamic environment in which firms have a preference, or pecking-order of preferred sources of financing, when all else is equal. Internally generated funds are the most preferred, new debt is next, debt-equity hybrids are next, and new equity is the least preferred source.

Outstanding share capital
Issued share capital less the par value of shares that are held in the company's treasury.

Other capital
In the balance of payments, other capital is a residual category that groups all the capital transactions that have not been included in direct investment, portfolio investment, and reserves categories. It is divided into long-term capital and short-term capital and, because of its residual status, can differ from country to country. Generally speaking, other long-term capital includes most non-negotiable instruments of a year or more like bank loans and mortgages. Other short-term capital i ...

Opportunity cost of capital
Expected return that is foregone by investing in a project rather than in comparable financial securities.

Nondiversifiability of human capital
The difficulty of diversifying one's human capital (the unique capabilities and expertise of individuals) and employment effort.

Net working capital
Current assets minus current liabilities. Often simply referred to as working capital.

Market capitalization rate
Expected return on a security. The market-consensus estimate of the appropriate discount rate for a firm's cash flows.

Market capitalization
The total dollar value of all outstanding shares. Computed as shares times current market price. It is a measure of corporate size.

Long-term debt/capitalization
Indicator of financial leverage. Shows long-term debt as a proportion of the capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and common stockholder equity.

Legal capital
Value at which a company's shares are recorded in its books.

Capital
Money invested in a firm.

Capital account
Net result of public and private international investment and lending activities.

Capital allocation decision
Allocation of invested funds between risk-free assets versus the risky portfolio.

Capital budget
A firm's set of planned capital expenditures.

Capital budgeting
The process of choosing the firm's long-term capital assets.

Capital Builder Account (CBA)
A Merrill Lynch brokerage account that allows investors to access the loan value of his or her eligible securities to buy or sell securities. Excess cash in a CBA can be invested in a money market fund or an insured money market deposit account without losing access to the money.

Capital expenditures
Amount used during a particular period to acquire or improve long-term assets such as property, plant or equipment.

Capital flight
The transfer of capital abroad in response to fears of political risk.

Capital gain
When a stock is sold for a profit, it's the difference between the net sales price of securities and their net cost, or original basis. If a stock is sold below cost, the difference is a capital loss.

Capital gains yield
The price change portion of a stock's return.

Capital lease
A lease obligation that has to be capitalized on the balance sheet.

Capital loss
The difference between the net cost of a security and the net sale price, if that security is sold at a loss.

Capital market
The market for trading long-term debt instruments (those that mature in more than one year).

Capital market efficiency
Reflects the relative amount of wealth wasted in making transactions. An efficient capital market allows the transfer of assets with little wealth loss.

Capital market imperfections view
The view that issuing debt is generally valuable but that the firm's optimal choice of capital structure is a dynamic process that involves the other views of capital structure (net corporate/personal tax, agency cost, bankruptcy cost, and pecking order), which result from considerations of asymmetric information, asymmetric taxes, and transaction costs.

Capital market line (CML)
The line defined by every combination of the risk-free asset and the market portfolio.

Capital rationing
Placing one or more limits on the amount of new investment undertaken by a firm, either by using a higher cost of capital, or by setting a maximum on parts of, and/or the entirety of, the capital budget.

Capital structure
The makeup of the liabilities and stockholders' equity side of the balance sheet, especially the ratio of debt to equity and the mixture of short and long maturities.

Capital surplus
Amounts of directly contributed equity capital in excess of the par value.

Capitalization method
A method of constructing a replicating portfolio in which the manager purchases a number of the largest-capitalized names in the index stock in proportion to their capitalization.

Capitalization ratios
Also called financial leverage ratios, these ratios compare debt to total capitalization and thus reflect the extent to which a corporation is trading on its equity. Capitalization ratios can be interpreted only in the context of the stability of industry and company earnings and cash flow.

Capitalization table
A table showing the capitalization of a firm, which typically includes the amount of capital obtained from each source - long-term debt and common equity - and the respective capitalization ratios.

Capitalized
Recorded in asset accounts and then depreciated or amortized, as is appropriate for expenditures for items with useful lives greater than one year.

Capitalized interest
Interest that is not immediately expensed, but rather is considered as an asset and is then amortized through the income statement over time.

Complete capital market
A market in which there is a distinct marketable security for each and every possible outcome.

Cost of capital
The required return for a capital budgeting project.

Cost of limited partner capital
The discount rate that equates the after-tax inflows with outflows for capital raised from limited partners.

Authorised capital
The maximum amount of share capital that a public limited company or a private limited company can issue according to its articles of association. Part of the authorised capital can remain unissued.

Basel II (Basel Capital Accord)
Basel II - short for the new Basel Capital Accord - lays down new guidelines for determining the minimum solvency requirements for banks. The main change in these guidelines is a new system for weighting the risks run by banks in their loans to retail and corporate customers. The objective of Basel II is to improve the soundness of the financial system.

Capital coverage ratio
Available capital divided by required capital.

Flight Capital
Money that flows offshore and likely never returns. Flight is exacerbated by a lack of confidence as government grows without bounds.

Risk Capital
Money put up by ordinary shareholders, an individual entrepreneur or venture capitalist that will be lost if the enterprise fails.

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 co ...