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Understanding and Calculating RORAC, RAROC, and RARORAC

Checklist

This checklist explains the differences between RORAC, RAROC, and RARORAC, and describes how to calculate and use them.

Definition

RORAC is the return on risk-adjusted capital. (Risk-adjusted capital is capital that has been adjusted after balancing the five main risk metrics--alpha, beta, r-squared, standard deviation, and the Sharpe ratio-- against each other so that return can be calculated on a level playing field.) It should not be confused with RAROC, which is risk-adjusted return on capital, and its close cousin, RARORAC, risk-adjusted return on risk-adjusted capital. The capital that is being invested, or risked, is usually called economic capital. RORAC is generally used to evaluate projects or investments that have a high element of risk for the capital involved. The RORAC formula (RORAC = Net income / Allocated economic capital) allows comparison of investments that have different levels of risk or different risk profiles. Here, the economic capital is adjusted for the maximum potential loss after calculating probable returns and/or their volatility. It is a very useful method of quantifying and managing acceptable levels of exposure to risk. Note that RORAC is used when the risk may vary according to capital assets used--it is the capital itself that is adjusted for those risks, rather than the rate of return. RAROC is a method for measuring risk-based profitability that also enables a consistent comparison of the risky financial returns of a range of projects or investments. It is usually defined as the ratio of risk-adjusted return to the economic capital. Rather than adjust the risk of the capital (as in RORAC), it is the risk of the return itself that is adjusted and measured. One of two formulae may be used: RAROC = Expected return / Economic capital, or RAROC = Expected return / Value at risk. Using capital based on risk improves the capital allocation across any scenario in which capital is risked for a return expected to be above the risk-free rate. RARORAC is increasingly used as a measure to assess both the risk-adjusted economic capital and the risk-adjusted return on an investment. It uses the capital adequacy guidelines as defined by Basel II. It is calculated by dividing the risk-adjusted return by the economic capital after including the diversification benefits.

Advantages

· These ratios allow for the incorporation of market risk, credit risk, and operational risk within a single comprehensive framework that shows the interrelationships between different sorts of risk and scenarios where there might be a too-high concentration of risks.

Disadvantages

· These ratios cannot cover systemic risks, which still need to be calculated separately.

Action Checklist

· Make sure you develop a risk-conscious compensation structure. By considering RORAC, rather than conventional, accounting-based, profit-and-loss calculations, it is possible to compensate managers for minimizing risk and maximizing return. Including RORAC in a company's compensation structure gives

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Understanding and Calculating RORAC, RAROC, and RARORAC

risk management authority, encourages responsible, longer-term decision making, and discourages the short-term "quarterly profits" mentality.

Dos and Don'ts

Do

· · Use these ratios to make informed decisions on the value of investments or projects and to create long-term strategies that bear risk in mind. Consider their use as part of the discipline of building a comprehensive risk management strategy.

Don't

· Don't forget that these ratios are flexible enough to apply as a metric to business models, cash flow projections, and other corporate financial conventions, as a means of integrating risk management from diverse areas.

More Info

Books:

· · · Crockford, Neil. An Introduction to Risk Management. Cambridge, UK: Woodhead-Faulkner, 1986. Lam, James. Enterprise Risk Management: From Incentives to Controls. Hoboken, NJ: Wiley, 2003. Tapiero, Charles. Risk and Financial Management: Mathematical and Computational Methods. Hoboken, NJ: Wiley, 2004.

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