RAROC and RORAC

Also known as: risk-adjusted return on capital and return on risk-adjusted capital

One of the most important innovations in value management is the consideration of the cost of equity. The cost of equity is an imputed approach for the compensation of the provision of capital in the time (that would be the interest rate) as well as for the assumption of risks on the part of the equity investor, the latter would be the risk premium.
In this way, success measurements and assessments of the advantageousness come about, which assess all activities, plans and projects against the background of the associated risks. Such success measurements and assessments take a risk adjustment of the result and thus lead to a measure of the performance.

One form of risk adjustment leads to RAROC, a very concretely defined key figure. Variants (RORAC, RARORAC) have since been added to this key figure. Occasionally the group of all these variants is referred to as RAROC.

1. RAROC means risk-adjusted return on capital and denotes a performance indicator. RAROC is equal to the return minus the risk premium. The key figure expresses what percentage was generated with the capital employed when the customary market remuneration for assuming the risks is settled.

2. The RAROC key figure (like any return) assumes that the amount of capital invested is precisely determined. However, no capital is assigned to individual businesses, projects, business units or parts of a company. Therefore a variant for the risk adjustment was suggested: RORAC (return of risk-adjusted capital).

If a business area is to be assessed with RORAC, the question is asked what types of risk (operational risks, market risks, counterparty risks) were associated with the business and "what could have happened there."
The responses from the risk controller are used to determine which capital investment is considered appropriate to cover these risks.
If, for example, it is said that customer claims of 1 million can arise as a result of errors in the case of operational risks, then it is assumed that this amount is "actually" required to bear these risks. The amount of capital required to bear market risks and counterparty risks is also determined.

The sum of the capital amounts, formed over the individual risk types, provides the “risk-adjusted capital” and thus the denominator of the RORAC key figure. The numerator shows the result of the period, for example a profit variable.

In companies in the financial sector in particular, these key figures have awakened the awareness that it is not only a question of the level of results that are achieved, but also of the risks that had to be taken in order to achieve these results.

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