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Risk-adjusted return on capital (RAROC)

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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.

 

Value at Risk (VaR)

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Value at Risk (VaR) is a summary, statistical measure of total normal market risk of loss (total value that can be lost) on a certain portfolio of financial instruments at a certain confidence level. It measures how large could be potential likely losses due to “normal” movements in the market. The technique is one of the most recent techniques and was developed at JP Morgan.

Value at Risk (VaR) results is structured as follows:

“with X% certainty, company will not lose more than $V in the next N days.”

Value at Risk (VaR) is a snapshot of a current risk level. The Value at Risk (VaR) is a floor for potential loss that can be incurred, not a ceiling. The potential loss can be VaR or higher. VaR is used to make sure that the company can handle potential losses. The potential losses cannot necessarily be prevented or, in some cases, potential losses should not necessarily be prevented due to risk/return relationship.

The results of Value at Risk (VaR) analysis are expressed as a single number $V (VaR number) which is determined based on two parameters namely X% which refers to confidence level and N days which refers to the time horizon. $V refers to the maximum potential loss which will occur with X% certainty over N days which is number of days in the risk period under consideration. For example, with 1% certainty over a 5 days period.

Value at risk limits can be established for specific asset categories such as foreign exchange or real estate. The limits can also be set for various levels within an enterprise such as business unit level and overall company level.

 

The Hurdle Rate

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The hurdle rate is also called minimum acceptable rate of return (abbreviated MARR) or break-even yield. It refers to the minimum rate of return that is required before any project can be undertaken. The hurdle rate is used in the capital budgeting and is the same as the required rate of return in the discounted cash flow analysis of long-term investment opportunities. It is a discount rate used when different investment alternatives are considered.

If the expected return on the proposed investment is below the hurdle rate, than the investment is not acceptable and vice versa. Sometimes the hurdle rate also refers to the minimum internal rate of return (IRR) for the project to be undertaken.

The hurdle rate should be equal to the marginal cost of capital, which is also referred to as the incremental cost of capital. The hurdle rate is also a rate of return which is necessary to maintain market value of the firm. The market value of the firm refers to the firm’s current market price of shares.

Organizations use hurdle rates to evaluate long-term investment projects using discounted cash flow techniques (capital budgeting). This allows assessing potential projects more systematically. Such evaluation allows having better confidence that selected long-term investments will at least have returns equal to the marginal cost of capital.

Hurdle rates should be set for each project or at least for each business unit or division to account for differences in risk profiles across the enterprise.

 

Aggregation of Risk Measures

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Consolidated risk management, which is also called enterprise-wide risk management, refers to synchronized management of total pool of risk in the enterprise. Consolidation of risks became possible due to advances in financial engineering and information technology.

Consolidation of risks is important for 5 main reasons:

  1. Consolidation of risks allows management to see the big picture of risk. Management able to see what is happening to the total pool of risk in the enterprise. Management can analyze if risks are increasing or decreasing and why such changes occur. Moreover, management is able to compare how such changes relate to the risk tolerance level of the enterprise.
  2. Since management is able to see the big picture, it is in a better position to make decisions on risk management which lead to improved performance of the enterprise risk management process.
  3. Improved performance of the enterprise risk management process leads to improved performance of the enterprise and enhanced owner’s wealth maximization, which is the ultimate objective of the enterprise.
  4. Consolidation of risks involves letting go of some particulars and allows to present risks in a straightforward and uncomplicated manner which facilitates effective management throughout the enterprise.
  5. Consolidation of risks involves analysis of the relationships between different risks. Thereafter, risks are categorized. This enhances quality of risk reporting, which in turn improves decisions associated with allocation of capital.

Approaches to consolidation of risks

Risks should be categorized into appropriate categories. If risks have the same drivers than risks are positively or negatively correlated. If risks do not have the same drivers than such risks are uncorrelated.

When risks are categorized, appropriate methods should be chosen to manage each category. Methods for managing categories of consolidated risks include:

  1. Managing it as a portfolio of risks
  2. Obtaining insurance for entire category or for each individual risk within category, whichever is less costly. Transfer costs for entire category will be more cost effective in cases when risks have low or negative correlation and high when risks have positive correlation.
  3. Hedging
  4. Using “natural hedges”. As an example, in 1984 a German airline Lufthansa signed a contract with American Boeing committing company to buy aircraft for $3 billion. The organization took forward contract for half of the amount (1.5 billion) to hedge itself against possible currency fluctuations. However, what was not taken into account is that Lufthansa’s cash flow was also essentially dollar-denominated. Therefore, Lufthansa had a “natural hedge” in this situation. Incidentally, the dollar depreciated by 30 percent in 1985 and Lufthansa incurred sizable foreign-exchange loss due to the forward contract which was unnecessary due to “natural hedge” that company had and which was overlooked.


Risk Monitoring

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Techniques to undertake risk monitoring include external and internal audits, appraisal of an enterprise’s risk management strategies, policies and procedures, and physical inspections.

Target outcome of risk monitoring

The target outcome of risk monitoring is to determine if the risk management objectives were achieved and which improvements can be made to enhance the risk management process. A number of questions should be answered during the risk monitoring stage:

  • Is the risk profile of the organization altered?
  • Are assumptions on which the risk management strategy were determined are still relevant?
  • Is the risk management process effective and efficient?
  • Does the risk management strategy still comply with government laws and regulations (if changes in laws and regulations occurred)?
  • How does the risk management process contribute to the ultimate objective of the enterprise, which is wealth maximization of the shareholders?

Risk monitoring of the risk management environment includes monitoring of environmental risks and operational risks.

  • Environmental risks refer to risks which occur in the external environment and over which the enterprise has no control. For example, if an unexpected adverse event occurs, management needs to re-evaluate the situation and adjust the organization’s risk management strategy and risk management implementation plan. This will ensure that unfortunate incidents do not evolve into a crisis.
  • Operational risks refer to risks which occur in the internal environment of the enterprise and over which enterprise has control.

Ongoing risk monitoring of the enterprise risk management (ERM) process allows enterprises to identify new risks in a timely manner. As an example a new risk, such as new regulatory requirements, can be identified and attended to in a timely manner. It allows maintaining an up to date organizational risk profile. Potential opportunities and threats are also paid attention to. It also makes possible to identify risk management practices that are inefficient or inappropriate, which must be followed by suitable adjustments. This allows decreasing costs of such practices.

Further, risk monitoring allows confirming if assumptions and analysis underlying risk management strategies and implementation plans were correct. If not, timely adjustments must be made, which will lead to further improvements in the efficiency of the process. Questioning every assumption may be too time consuming. In such case, a list of key assumptions must be compiled and monitored.

Benchmarking

One of the ways to improve the risk management process is by using benchmarking methodology. Benchmarking refers to comparing certain performance indicators of the business to those of the competitors. It also can refer to comparing certain performance indicators between business units within the same enterprise. This methodology can be expensive and time consuming. Therefore, focusing on the crucial areas for success of the risk management process may be most appropriate.

Risk management training should also be undertaken to ensure employees’ improvement in risk management abilities, skills, knowledge and awareness, and to further enhance quality of risk monitoring.

 

Enterprise Risk Management Function

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Enterprise risk management refers to the new strategic process of structured identification and evaluation of all the risks and opportunities of the enterprise, determination of appropriate ways of managing and controlling such risks, and monitoring of this risk management process.

History of risk management

The origin of risk management as a role within a company is attributed to Fayol who is regarded as a father of management. In his 1916 article he proposed 6 functions of management which included a security function. The security function was associated with protection of people and property. The current risk management function is much more comprehensive but Fayol’s security function was a first glimpse of the current risk management function. The importance of a proper risk management function was acknowledged in 1960s in USA and thereafter spread around the world.

The term “risk management” was formally used only from the 1950s. Initially, the risk management function was closely associated with insurance. This slowed down the development of the function. The first book on risk management was entitled “Risk management in the business enterprise” was written by Robert I Mehr.

Enterprise Risk Management and Culture

Enterprise risk management incorporates risk awareness into the culture of the organization. The risk culture of the organization significantly contributes to the success of the enterprise risk management. Employees need to see risk as an integral variable which needs to be managed, controlled and monitored. Each employee needs to understand their role in the risk management of the enterprise. Leadership support of the importance of risk management significantly contributes to adequate risk management culture.

Enterprise risk management uses advances in technology for management of risk.

Enterprise-wide in the enterprise-wide risk management refers to the elimination of barriers between functions, departments and other groupings within the organization.

Risk management infrastructure & risk management capabilities – To ensure effective enterprise risk management processes, organizations need to establish an adequate set of risk management capabilities. Risk management capabilities refer to the abilities of an organization that allow it to undertake effective risk management processes. It includes abilities which allow for identification, measurement, management and monitoring of risks.

An appropriate set of risk management capabilities allows the organization to have a clear understanding of how their risk management decisions affect the bottom line and long term wealth maximization of the shareholders, which is the ultimate objective of the enterprise.

If an evaluation established that additional risk management capabilities are required, it is important to undertake cost-benefit analyses to ensure that the cost of additional risk management capabilities will be more than offset by the benefits that it will bring.

Certain risk capabilities which are adequate in one company to manage specific risk may be inadequate for another company which attempts to manage the same risk. Each organization must select risk management capabilities suitable to its particular individual needs, based on the particular risk exposure.

Risk management process monitoring and adjustment

The existing business environment is very turbulent. Risk exposures and factors affecting risks may alter all the time. Therefore, ongoing risk monitoring and adjustment of risk management strategies become an increasingly important step in the enterprise risk management process.

An organization needs to gain a good understanding of the risk management process. The main goal of the risk management monitoring process is to assess how effective the risk management process is.

Why risk management monitoring is important?

The main goal of risk management monitoring is to determine effectiveness of the enterprise risk management process. If the risk management process is not adequately monitored, shortcomings of the process may negatively affect achievement of the strategic objectives of the enterprise.

Ongoing monitoring of the performance of the risk management process and risk management environment leads to continuous improvement of the entire enterprise risk management process.

To monitor risk management performance, risk management performance standards should be established against which performance can be measured. Such standards may include areas such as time tables within which certain goals should be achieved, budgets and specific areas of enterprise’s performance which is vital for organizational success. After performance standards are established, they must be monitored on an ongoing basis.

The Rise of Corporate Governance

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Over the last few years Corporate Governance became a very important consideration for any business around the world. After corporate scandals such as Enron and Worldcom in the USA and Independent Insurance Co in the UK, investors and governments demanded better corporate governance practices by the businesses.

Various measures were taken by governments to prevent further corporate scandals. For example, US introduced the Sarbanes-Oxley Act 2002, to comply with which placed a significant financial burden on businesses.

Ehlers and Lazenby define corporate governance in the narrow sense as the formal system of accountability of the board of directors to shareholders and in the broad sense as an informal and formal relationship between the corporate sector and its stakeholders and the impact of the corporate sector on society.

To succeed in contemporary environment, companies need to have reputation of having a strong corporate governance. Triple bottom line principle (“people, planet, profit” or “the three pillars”) became prominent. It refers to the principle according to which enterprises measured by and must report on it’s economic, social and environmental performances. This is in contrast with the past when only reporting on economic performances (single bottom line) were required.

Corporate governance is beneficial to the firm in many respects. What is most important is that it increases long-term performance on the enterprise-wide basis. Therefore, it increases shareholder’s wealth, which is the main objective of the business.

Proper corporate governance also benefits society and country as a whole. For example, if country’s businesses are known for maintaining proper corporate governance, foreign capital will flow into the country as foreign investors will be interested in investing in the country’s businesses.

Within the country, resources also will be used more efficiently due to good corporate governance. In such environment investors will be investing into companies with biggest potential to deliver value to customers and inefficient management will be replaced in underperforming businesses.

Further, society and communities will benefit in various ways. For example, enterprises with proper corporate governance comply with laws and regulations, such as requirements with respect to pollution. Overall, good corporate governance benefits all stakeholders of the enterprise and is a prerequisite for success of any business.

 

Risk Categories

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There are two main risk categories, speculative risk and an event risk.

The ultimate goal of the firm is to maximize shareholder’s wealth. The environment is changing rapidly and any change may result in additional risks and losses. Therefore, effective enterprise risk management is essential to ensure achievement of the main objective of the enterprise, which is maximizing wealth of the shareholders. Both risk categories should be diligently managed.

Speculative risks can result in a gain or loss, such as fluctuating interest rates. An enterprise may protect itself from adverse effects of speculative risks by various techniques such as hedging. Speculative risks are further subdivided into core business risks and incidental risks.

Core business risks are part of the main business of the enterprise and reflected in the mission statement. Core business risks may negatively impact the operating profit of the enterprise. Core business risks can be specific (unsystematic) and market (systemic).  Specific risks include risks which impact only the enterprise and do not impact the economy as a whole. Specific risks include those associated with sales variability, operating leverage, resource risk, profit margin and turnover. Specific risks are also called diversifiable risk. Systemic risks are risks which impact the economy and the enterprise. Systemic risks entail occurrence of a negative market-wide event such as the risk of collapse of an entire market. It is also called un-diversifiable risk. Investors require higher returns for increases in systemic risk.

Incidental risks are risks that occur naturally in the business but are not part of the main business. However, control of such risks is vital to ensure survival of the enterprise.

Whether a risk is considered to be core or incidental sometimes depends on the activities of the enterprise. For example, interest rate risk will be a core business risk for financial institution and incidental business risk for a manufacturing enterprise.

Event risks can result in losses, such as fire, or can result in no loss but cannot result in any gain. A business may protect itself from adverse effects of event risks by various techniques such as insurance. Event risks can be fundamental or particular.

Fundamental event risks refer to impersonal losses on the macro level.

Particular event risks refer to personal losses on micro level such as a car accident.

Event risks are subdivided into operational and external downside risks:

Operational risks further subdivided into people, processes and systems risks. It refers to risks which occur due to failures during execution of operations.

External downside risks are risks that cannot be directly controlled by an enterprise and which can occur due to external factors. External downside risks are all risks that occur due to external factors that may have no affect or adverse effect on the enterprise. External downside risks are very difficult to manage. Examples of external downside risks include natural disasters, terrorist attacks, criminal threats and litigation.

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The Theory of Probability

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Probability refers to the chance that an event will occur. To calculate probability of the outcome we need to take number of occurrences and divide it by total number of possible outcomes.The lowest probability is 0 and the highest is 1.

Probability = number of occurrences / total number of possible outcomes

For example, we can take number of household fires over certain period in a certain area and divide it by total number of households in the same area. This will give us a probability of fire in the households in this particular area.

 

What is Risk?

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So what is risk? Risk is the possibility that actual results will differ from desired or expected results. It implies the presence of uncertainty (uncertainty about the occurrence of event and uncertainty that it will display a particular outcome).

The degree of risk is determined by 2 factors:

  1. How often an event will occur?
  2. What is the probability the particular outcome will occur?

In business, it is generally accepted that as the risk increases, the expected or required return should also increase. It is not good for businesses to eliminate all risk because with elimination of risk, profits will likely decrease.

When thinking about risk and uncertainty the following description may help. Risk is binary. There is either risk or there is no risk. It’s either a yes or no. The degree of risk is the uncertainty. So we can say that yes, there is a risk it will rain in Paris today. We think there is high certainty it will happen. We are 80% confident it will happen. So there is either a risk (1) or no risk (0). The degree of risk (uncertainty) can be any number from 0 to 1. Risk is a possibility while uncertainty is a probability.

What is needed for an effective risk management process?

Risk management processes refer to the procedures that consist of systematic control activities and monitoring of risk management performance to ensure that risks in the organization are adequately managed.

According to Lore and Borodobsky, risk management have 3 dimensions:

  1. Upside management – taking advantage of opportunities where the business has very good chances to achieve success.
  2. Downside management – controls must be implemented to prevent or decrease losses due to operating environment.
  3. Uncertainty management – using techniques and methods to decrease deviations from expected results.

For effective risk management, organizations must deploy consistent risk measures, identify and manage all important risks, undertake proper management controls and support management of risks through performance evaluation on the business unit and organizational level.

Certainty and uncertainty

Certainty occurs when the outcome is 100% going to happen as expected. For example, the sun will rise tomorrow.

Uncertainty occurs when one does not have knowledge about future outcomes. Uncertainty is not the same as risk.There are different degrees of uncertainty, from almost certain to completely uncertain. Uncertainty increases the further into the future we attempt to plan. One’s access to information and ability to use available information in the decision making process determines the perceived degree of uncertainty.