For a time, it was widely believed that the only way to determine how good an investment is, was by looking at its return. But in recent years, investors have come to realize that a high return doesn’t always equal a good investment.
For example: if one company has a higher return than another but is also riskier – then the lower-returning but lower-risk company might be the better choice for many people. In order to account for risk when evaluating investments, some experts now use what’s called “RAROC” or “Risk-Adjusted Return of Capital.”
The idea behind this calculation is simple: you look at both returns and risks and calculate which investment will provide more money on average over time (taking into account the risks involved).
In this article, we will be looking at what is Risk-Adjusted Return on Capital (RAROC ) is, how it is calculated, and what the advantages and disadvantages are to using it.
What is Risk-Adjusted Return on Capital (RAROC)
Risk-Adjusted Return on Capital (RAROC) is a way of determining whether an investment’s returns are reasonable, given the amount of risk it carries. The calculation for RAROC will reveal how much money an investor can expect to earn, per unit of risk that he or she takes. You calculate RAROC by taking the return of investment and adjusting it for risk.
How to Calculate Risk-Adjusted Return on Capital (RAROC)
Calculating RAROC is a fairly straightforward process. You take the estimated return of investment and divide it by the standard deviation to get a number known as “beta.” The beta which you will be using in your calculation will depend on what type of risk-adjusted return on capital you are calculating.
RAROC = average return/ standard deviation
Riske-Adjusted Return on Capital can be used to show how much money an investor will earn, per unit of risk taken.
Risk-Adjusted Return on Capital (RAROC) Advantages
There are several advantages to the use of RAROC
- It provides a good way of evaluating different investments with different risks
- It allows you to make more precise comparisons among risky assets
- By understanding the risk-return tradeoff, investors can better plan their portfolios and make smarter financial decisions. One of the biggest causes of bankruptcy is risk management
- It enables you to estimate the value of a business
- It allows you to make accurate decisions about the efficiency of your company
Risk-Adjusted Return on Capital (RAROC) Disadvantages
While RAROC provides a number of advantages, there are also several disadvantages to its use
- Calculating returns for investment often involves looking at past performance, which can be misleading if you don’t take into account the effects of inflation or other factors over time
- Risk-adjusted return on capital only works in a theoretically perfect market, but not in a real-world setting where you can’t assume that all risk is priced into an investment
- Different measures for risk are used by different companies/individuals and come with their own sets of disadvantages
- The market prices of risk can change quickly and unpredictably, which means that RAROC can become obsolete very fast
- Risk-adjusted return on capital doesn’t tell you what the returns are expected to be in the future
Conclusion
Risk-Adjusted Return on Capital (RAROC) provides a good way to get a snapshot of an investment’s risk-reward profile. It allows you to compare the expected returns on different investments that are taking on different amounts of risk. Additionally, it can give you insight into business value by giving you a benchmark for estimating the present value of future cash flows.
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