Tag Value at risk

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.