Return on Risk-Adjusted Capital (RORAC)

What Is Return on Risk-Adjusted Capital (RORAC)?

The return on risk-adjusted capital (RORAC) is a rate of return measure generally utilized in financial analysis, where various projects, endeavors, and investments are assessed in light of capital at risk. Projects with various risk profiles are simpler to compare with one another once their individual RORAC values have been calculated.

The RORAC is like return on equity (ROE), with the exception of the denominator is adjusted to account for the risk of a project.

The Formula for RORAC Is

Return on Risk-Adjusted Capital is calculated by separating a company's net income by the risk-weighted assets.
$\begin &\text=\frac{\text}{\text}\ &\textbf\ &\text{Risk-Weighted Assets = Allocated risk capital, economic}\ &\text{capital, or value at risk}\ \end$

What Does Return on Risk-Adjusted Capital Tell You?

Return on risk-adjusted capital (RORAC) considers the capital at risk, whether it be connected with a project or company division. Allocated risk capital is the firm's capital, adjusted for a maximum potential loss in light of estimated future earnings distributions or the volatility of earnings.

Companies use RORAC to place greater accentuation on vast risk management. For instance, unique corporate divisions with unique managers can utilize RORAC to evaluate and keep up with acceptable risk-openness levels.

This calculation is like risk-adjusted return on capital (RAROC). With RORAC, nonetheless, the capital is adjusted for risk, not the rate of return. RORAC is utilized when the risk varies relying upon the capital asset being investigated.

Illustration of How to Use RORAC

Expect a firm is assessing two projects it has participated in over the previous year and requirements to choose which one to take out. Project A had total revenues of $100,000 and total expenses of $50,000. The total risk-weighted assets implied in the project is $400,000.

Project B had total revenues of $200,000 and total expenses of $100,000. The total risk-weighted assets implied in Project B is $900,000. The RORAC of the two projects is calculated as:
$\begin &\text=\frac{$100,000-$50,000}{$400,000}=12.5$
Despite the fact that Project B had two times as much revenue as Project A, when the risk-weighted capital of each project is considered, obviously Project A has a better RORAC.

The Difference Between RORAC and RAROC

RORAC is like, and effectively mistook for, two different statistics. Risk-adjusted return on capital (RAROC) is generally defined as the ratio of risk-adjusted return to economic capital. In this calculation, rather than adjusting the risk of the actual capital, the risk of the return is evaluated and measured. Frequently, the expected return of a project is separated by value at risk (VaR) to show up at RAROC.

Another statistic like RORAC is the risk-adjusted return on risk-adjusted capital (RARORAC). This statistic is calculated by taking the risk-adjusted return and separating it by economic capital, adjusting for diversification benefits. It utilizes rules defined by the international risk standards covered in Basel III — which is a set for changes that are to be carried out by Jan. 1, 2022, and is intended to work on the regulation, supervision, and risk management inside the banking sector.

Limitations of Using Return on Risk-Adjusted Capital - RORAC

Computing the risk-adjusted capital can be unwieldy as it requires figuring out the value at risk calculation.

For related understanding, read more about how risk-weighted assets are calculated based on capital risk.

Features

• Return on risk-adjusted capital (RORAC) is usually utilized in financial analysis, where various projects or investments are assessed in view of capital at risk.
• Like risk-adjusted return on capital, RAROC contrasts in that it changes the return for risk and not the capital.
• RORAC takes into account consistent comparison of projects with various risk profiles.