Risk-Adjusted Return on Capital (RAROC): Financial Modeling Training

Risk-Adjusted Return on Capital (RAROC): Financial Modeling Training
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Chandana

Published on July 24, 2013


  • 7609 Views

RAROC is an essential concept of finance and a must study for Financial Modeling certification exam preparation. Anyone looking forward towards attaining a Financial Modeling Certification needs to be aware of this concept with in depth understanding. Let’s have a look at RAROC in this post. RAROC means Risk-Adjusted Return on Capital. As the term suggests, it is a measure of return that takes risk into account. There are different types of such measures. The RAROC measures include two elements that are mentioned as below.

  • The concept of expected Cash Flow and by extension expected return: This includes the IRR or internal rate of return that consists in using expected cash-flows instead of simple cash-flows in the IRR calculation.
  • An element of risk: This extension of capital measure involves risk within its calculation.  This consists of incorporating risk into the profitability measure.

A RAROC measure is defined as RAROC = Expected Return / Risk There are many possible definitions of RAROC. This is because there are various possible definitions of Risk as well. Two possible RAROC measures are stated as below.

  • RAROC = Expected Return / Volatility of Returns
  • RAROC = Expected Return / Tail Risk

Let’s go through an example on RAROC calculation. Suppose, the investment here has the following cash-flows:
CF=-10 at t=0
At t=1 year, t=2 years, …., t=9years:
CF=1 with probability 0.95
CF=0 with probability 0.05
At t=10 years: CF=10 with probability 0.95
CF=0 with probability 0.05

For the risk measure in the RAROC we use the value of the IRR if all CF end up being >0 except the CF at t=10 assumed to be 0. First calculating the expected CFs for each date, secondly, deriving the expected IRR (8.524%) and finally deriving RAROC: we get RAROC = 8.524%/-2.06%= -2.81914. To know more about Risk-adjusted return on capital or RAROC, you can explore our training courses on Financial Modeling. Simplilearn offers both online and classroom training on Financial Modeling.

About the Author

Chandana is working as a Senior Content Writer in Simplilearn.com and handles variety of creative writing jobs. She has done M.A. in English Literature from Gauhati University. A PRINCE2 Foundation certified, she has a unique and refreshing style of writing which can engross the readers to devour each sentence of her write-ups.


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