RAROC stands for Risk-Adjusted Return on Capital. It is a risk-based profitability measurement framework for analyzing risk-adjusted financial performance and providing a consistent view of profitability across businesses. RAROC is calculated as the ratio of risk-adjusted return to economic capital.
Components of RAROC
The two main components of RAROC are:
- Risk-adjusted return: This is the amount of profit that is generated by a business after taking into account the risks involved. It is calculated by subtracting the expected losses from the revenues and expenses.
- Economic capital: This is the amount of capital that a business needs to have in order to withstand its risks. It is calculated by taking into account the probability and severity of different risks.
Formula for RAROC
The formula for RAROC is:
RAROC = (Revenues - Costs - Expected losses) / Economic capital
Advantages of RAROC
RAROC has a number of advantages over traditional profitability measures such as return on equity (ROE) and return on assets (ROA). These advantages include:
- RAROC takes into account the risks involved in a business, which gives a more accurate picture of its profitability.
- RAROC can be used to compare the profitability of different businesses, even if they have different levels of risk.
- RAROC can be used to set targets for profitability and to track progress towards those targets.
Disadvantages of RAROC
RAROC also has some disadvantages, such as:
- RAROC can be complex to calculate and understand.
- RAROC can be sensitive to the assumptions that are made about the risks involved in a business.
- RAROC is not always a good measure of profitability for businesses that are not exposed to much risk.
M&Qs on RAROC
1. What is the purpose of RAROC?
RAROC is used to measure the profitability of a business after taking into account the risks involved. It is a more accurate measure of profitability than traditional profitability measures such as ROE and ROA, because it takes into account the risks involved.
2. What are the two main components of RAROC?
The two main components of RAROC are risk-adjusted return and economic capital. Risk-adjusted return is the amount of profit that is generated by a business after taking into account the risks involved. Economic capital is the amount of capital that a business needs to have in order to withstand its risks.
3. What is the formula for RAROC?
The formula for RAROC is:
RAROC = (Revenues - Costs - Expected losses) / Economic capital
4. What are the advantages of RAROC?
RAROC has a number of advantages over traditional profitability measures such as ROE and ROA. These advantages include:
- RAROC takes into account the risks involved in a business, which gives a more accurate picture of its profitability.
- RAROC can be used to compare the profitability of different businesses, even if they have different levels of risk.
- RAROC can be used to set targets for profitability and to track progress towards those targets.
5. What are the disadvantages of RAROC?
RAROC also has some disadvantages, such as:
- RAROC can be complex to calculate and understand.
- RAROC can be sensitive to the assumptions that are made about the risks involved in a business.
- RAROC is not always a good measure of profitability for businesses that are not exposed to much risk.