Risk-adjusted return on capital
What is risk-adjusted return on capital?
Risk-adjusted return on capital (RAROC) is a metric that can be used to calculate return in relation to the level of risk taken on. It can be used to compare the performance of multiple investments with differing levels of risk exposure. It is calculated by dividing expected return by risk.
Where have you heard about risk-adjusted return on capital?
The risk-adjusted return on capital metric was developed by Banker’s Trust in the 1970s to give a better sense of the firm’s risk/reward profile, more than the more simple return-on-capital (ROC). It has become widely used in the financial markets to measure risk as part of the Basel III reporting requirements.
What you need to know about risk-adjusted return on capital.
The use of risk-adjusted return on capital (RAROC) enables firms to determine the level of risk in each line of business and to allocate the required amount of capital accordingly. The use of risk adjusted returns can be used to calculate performance, which aids the diversification of the composition of an investment portfolio. If two separate lines of business in a company make the same return on capital but did so whilst taking on differing degrees of risk, the business with less risk will have the higher RAROC whilst the riskier project will have the lower RAROC.