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.
