# Understanding RAROC: Formula and Benefits of Risk-Adjusted Return on Capital

![Risk-Adjusted Return on Capital (RAROC): A modified return on investment figure that takes elements of risk into account.](https://www.investopedia.com/thmb/J-cItNKlT03D6vJ8Tcjtd5gF9uo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Raroc_final_rev-0caef13f2f3742c4a5754e72dcb67e7b.png)

*— Investopedia / Michela Buttignol*

> **Definition**
>
> The risk-adjusted rate on capital is a financial metric that adjusts the profitability of an investment by its expected risk.

Risk-adjusted return on capital ([RAROC](https://www.investopedia.com/terms/r/riskadjustedreturn.asp)) measures investment returns while accounting for risk. This refined ROI helps compare investments of varying risk levels by adjusting returns with expected losses and income from capital. It is extensively used by financial institutions for assessing potential acquisitions and determining profitability across business sectors.

### Key Takeaways

*   Risk-adjusted return on capital (RAROC) adjusts investment returns for risk, aiming for clarity in financial decision-making.
*   RAROC, developed by Bankers Trust in the 1970s, is widely used in banks and financial sectors for evaluating profits across industries.
*   The formula for RAROC takes into account revenue, expenses, expected losses, capital income, and overall capital.
*   RAROC is distinct from similar measures by incorporating risk factors, offering a nuanced view of potential returns.

## The Formula For RAROC Is

﻿ $\begin{aligned}&RAROC=\frac{r-e-el+ifc}{c}\\&\textbf{where:}\\&\text{RAROC}=\text{Risk-adjusted return on capital}\\&r=\text{Revenue}\\&e=\text{Expenses}\\&el=\text{Expected loss which equals average loss}\\&\phantom{el=}\text{expected over a specified period of time}\\&ifc=\text{Income from capital which equals}\\&\phantom{ifc=}\text{(capital charges)}\times{\text{(the risk-free rate)}}\\&c=\text{Capital}\end{aligned}$﻿

## How RAROC Provides Insight into Investment Risk

Risk-adjusted return on capital is a useful tool in assessing potential acquisitions. RAROC assumes riskier investments offer higher returns. Companies that need to compare two or more different projects or investments must keep this in mind.

## The Origins of RAROC at Bankers Trust

RAROC, a risk-based profitability measure, helps analysts assess financial performance across sectors.

Bankers Trust, led by Dan Borge, developed the RAROC metric in the late 1970s. The tool grew in popularity through the 1980s, serving as a newly developed adjustment to simple return on capital (ROC). Bankers Trust, then a commercial bank, shifted to an investment bank model, focusing on securities and derivatives.

These wholesale activities facilitated the development of the RAROC model. Publicity spurred other banks to create their own RAROC systems, often under different names but for the same metric. Other methods include return on risk-adjusted capital (RORAC) and risk-adjusted return on risk-adjusted capital (RARORAC). The most commonly used is still RAROC. Non-banking firms utilize RAROC as a metric for the effect that operational, market and credit risk have on finances.

## Exploring RORAC: A Comparison with RAROC

Not to be confused with RAROC, the return on risk-adjusted capital ([RORAC](https://www.investopedia.com/terms/r/rorac.asp)) is used in financial analysis to calculate a rate of return, where projects and investments with higher levels of risk are evaluated based on the amount of capital at risk. Companies increasingly use RORAC as [risk management](https://www.investopedia.com/terms/r/riskmanagement.asp) becomes more emphasized. The calculation for this metric is similar to RAROC, with the major difference being capital is adjusted for risk with RAROC instead of the rate of return.

## How Can You Determine the Expected Loss From Capital?

Calculating RAROC requires knowing the expected loss from an investment. To find this number, you'll need to estimate the odds of failure or default and multiply that by the loss that you'd experience in the event of that failure.

## What Are Other Methods of Assessing Risk and Return?

There are many tools that investors and business analysts can use to assess the risk and return of potential investments. For example, investors may look at the [Sharpe ratio](https://www.investopedia.com/terms/s/sharperatio.asp) of an investment, which compares the return of an investment and its standard deviation from that return to the risk-free rate of return.

## Are There Drawbacks to Using Risk-Adjusted Return on Capital?

Yes, risk-adjusted return on capital is an imperfect measure and there are drawbacks to using it. One drawback is that calculating it can be difficult and require a lot of data because you need to estimate potential losses. An overreliance on RAROC can also lead to bad decisions. An investment with a high RAROC can still be a poor choice of the risk of failure is incredibly high.

## How Does Risk-Adjusted Return on Capital Differ from Other Return on Investment Measures?

RAROC differs from other methods of determining the return on investment because it considers the risks involved. If you can double your money by predicting the outcome of a coin flip or lose it for being incorrect, the ROI on a successful flip is 100%, but the RAROC would only be 50% because of the expected loss involved. This means RAROC offers a more thorough understanding of an investment's potential returns.  

## The Bottom Line

Risk-adjusted return on capital (RAROC) provides a valuable framework for financial analysts and investors to assess and compare various investments, incorporating the element of risk. By evaluating potential investments with RAROC, they can identify opportunities that promise higher returns relative to the inherent risks. However, it is important to be mindful of its limitations and not rely solely on this metric, as high RAROC does not eliminate the risk of significant failure. Calculating RAROC is an essential tool for those who aim to optimize the use of their capital and make more informed investment decisions.

> **Article Sources**
>
> 1.  Capital.com "[What is expected loss](https://capital.com/expected-loss-definition)?" Accessed Jul. 24, 2024.