What is RAROC

RAROC (Risk-Adjusted Return on Capital) is a financial metric that measures the amount of return earned on an investment adjusted for the amount of risk taken. It is widely used in the banking and financial services industry to evaluate the profitability of a particular investment or business line.

The concept of RAROC was developed in the early 1990s by Bankers Trust, a global investment bank that was later acquired by Deutsche Bank. Bankers Trust developed RAROC as a way to allocate capital to different business lines and to ensure that each business line was generating an adequate return on the capital invested.

The basic formula for calculating RAROC is:

RAROC = (Expected Return - Risk-Free Rate) / Risk-Adjusted Capital

Expected return is the amount of return that an investment is expected to generate, based on various factors such as market conditions, interest rates, and the performance of the investment itself. The risk-free rate is the rate of return that an investor could earn with zero risk, typically measured by the yield on government bonds. Risk-adjusted capital is the amount of capital that is allocated to a particular investment or business line, adjusted for the level of risk associated with that investment or business line.

The idea behind RAROC is that different investments or business lines will have different levels of risk, and therefore require different levels of capital to be invested in them. By adjusting the amount of capital allocated to each investment or business line based on its level of risk, a bank or financial institution can ensure that it is earning a sufficient return on its overall capital.

For example, suppose a bank is considering investing in two different business lines. Business line A has an expected return of 10%, but is considered to be relatively risky, with a risk-adjusted capital requirement of $1 million. Business line B has an expected return of 8%, but is considered to be less risky, with a risk-adjusted capital requirement of only $500,000.

Using the RAROC formula, we can calculate the RAROC for each business line:

RAROC(A) = (10% - 2%) / $1 million = 8%
RAROC(B) = (8% - 2%) / $500,000 = 12%

In this example, even though Business line A has a higher expected return than Business line B, its RAROC is lower because it requires more capital to be invested due to its higher risk profile. Business line B has a higher RAROC because it requires less capital to be invested due to its lower risk profile.

RAROC is an important tool for financial institutions because it allows them to make more informed decisions about how to allocate capital to different business lines or investments. By calculating the RAROC for each investment or business line, a bank can identify which ones are generating the highest returns relative to the amount of risk taken, and can allocate capital accordingly.

One potential downside of RAROC is that it can be difficult to accurately estimate the risk associated with a particular investment or business line. Risk is inherently uncertain, and even sophisticated risk models can be subject to errors or biases. As a result, RAROC should be used in conjunction with other risk management tools and should be regularly reviewed and updated based on changes in market conditions or other factors that may affect the risk profile of a particular investment or business line.

RAROC is a useful tool for financial institutions to evaluate the profitability of different investments or business lines. By adjusting the amount of capital allocated to each investment or business line based on its level of risk, RAROC allows banks to maximize their overall return on capital while managing their overall risk exposure. However, RAROC should be used in conjunction with other risk management tools and should be regularly reviewed and updated to ensure its

One important aspect of RAROC is that it takes into account the opportunity cost of investing in a particular business line or investment. The risk-free rate used in the RAROC formula represents the return that could be earned by investing in a risk-free asset, such as government bonds. By subtracting the risk-free rate from the expected return of an investment, RAROC accounts for the fact that there is a cost to taking on risk.

Another key feature of RAROC is that it is a risk-adjusted measure of return. This means that it evaluates the return earned on an investment relative to the level of risk taken to earn that return. By adjusting for risk, RAROC helps financial institutions to identify investments or business lines that are generating high returns but also pose a high level of risk. This information can be used to make decisions about whether to continue investing in a particular business line or to adjust the amount of capital allocated to that business line.

Financial institutions often use RAROC to set risk-adjusted hurdle rates for investments or business lines. Hurdle rates are minimum rates of return that an investment or business line must achieve in order to justify the level of risk taken. By setting hurdle rates based on RAROC, financial institutions can ensure that they are earning a sufficient return on capital while managing their overall risk exposure.

It's worth noting that RAROC is not the only measure of risk-adjusted return that is used in the financial industry. There are a number of other metrics that are used to evaluate the risk-adjusted return of investments, including Sharpe ratio, Treynor ratio, and Jensen's alpha. Each of these metrics has its own strengths and weaknesses, and financial institutions may use a combination of measures to evaluate the risk-adjusted return of their investments.

In conclusion, RAROC is a powerful tool for financial institutions to evaluate the profitability of different investments or business lines. By adjusting the amount of capital allocated to each investment or business line based on its level of risk, RAROC allows banks to optimize their overall return on capital while managing their overall risk exposure. While RAROC is not the only metric used to evaluate risk-adjusted returns, it is widely used in the financial industry due to its simplicity and flexibility.