Risk-adjusted performance measures allow to measure risks and returns of investments to be able to rank investments systematically.
Risk-adjusted return on capital (RAROC) is an example of a risk-adjusted performance measure. RAROC was introduced and popularized by Bankers Trust in the late 1970s and 1980s as an enhancement of return on capital (ROC).
RAROC is often measured as a ratio. To find risk-adjusted return on capital (RAROC) we need to take expected revenue less expected expenses less expected losses (losses expected over the measurement period) and risk free rate of return divided by capital to be invested.
RAROC discount riskier cash flows against less risky cash flows.
When risk is quantified with the use of approaches such as Value at Risk (VaR), one of the ways to use quantified risk information is to evaluate the value of business activities versus their risk profiles. Two businesses with the same income but different risk levels have different value.
RAROC evaluates the risk of business activity and associated expected return from business activity. RAROC allows to evaluate how much more of the expected return is required for each degree of risk and whether there is enough funds available to cover potential risks.
To quantify risk we use probability distributions of return obtained from historical records. This should be consistent with Value at Risk (VaR) and other statistical models. The goal is to consolidate risk, price risk and allocate capital based on expected returns.
RAROC allows to evaluate risk, return and to compare the performance of various enterprise’s units and activities each of which will have different risk portfolios. This will allow creating benchmarks. RAROC determines limits on different business activities such as trading or investing by adjusting return on an investment that accounts for capital at risk. RAROC allows comparing returns on a variety of projects with diverse levels of risk.
RAROC is a way to measure profitability in light of the degree of risk of the business activity.