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What is the best way to use RAROC for evaluating your investment portfolio?

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If you are an investment banker, you probably know that RAROC stands for risk-adjusted return on capital. It is a metric that measures the profitability of an investment or a portfolio relative to the amount of risk involved. But how can you use RAROC to optimize your investment decisions and align them with your risk appetite and strategy? In this article, we will explain the basics of RAROC, how to calculate it, and how to apply it to your portfolio.

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1 What is RAROC?

RAROC is a ratio that compares the expected return of an investment or a portfolio to the economic capital required to support it. Economic capital is the amount of money that a bank or a financial institution needs to hold as a cushion against potential losses from unexpected events, such as market shocks, credit defaults, or operational failures. RAROC helps you assess how efficiently you are using your capital to generate returns, and whether you are taking too much or too little risk for your desired level of return.

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2 How to calculate RAROC?

To calculate RAROC, you need to estimate two components: the expected return and the economic capital. The expected return is the net income or cash flow that you anticipate to receive from an investment or a portfolio over a given period, usually one year. The economic capital is the amount of capital that you need to allocate to an investment or a portfolio to cover the potential losses at a certain confidence level, usually 99.9%. You can use different methods to estimate the economic capital, such as value at risk (VaR), stress testing, or internal models. Once you have these two components, you can simply divide the expected return by the economic capital to get the RAROC.

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3 How to use RAROC for your portfolio?

RAROC can help you evaluate and compare the performance of different investments or portfolios based on their risk-return profiles. This process can be used to select the optimal mix of assets that maximizes your return for a given level of risk, or minimizes your risk for a given level of return, which is also known as the efficient frontier of your portfolio. Additionally, RAROC can be used to set risk-adjusted performance targets and benchmarks for portfolio managers or business units, allowing them to be rewarded based on their RAROC goals. Furthermore, you can use RAROC to ensure that your portfolio aligns with your risk appetite and strategy by defining a minimum acceptable RAROC (MAROC) based on your risk tolerance and strategic objectives.

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Luiz Gabriel Todt de Azevedo

Chief Strategy Officer (CSO) at IDB Invest - Strategy, Impact, and Sustainability Senior Executive / Board Member
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Very important for development Banks to combine the goal of impact with a RAROC, to have a sense of the returns and risks involved in the allocation of capital.

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4 What are the benefits of RAROC?

RAROC has several benefits as a portfolio management tool, such as the ability to compare different types of investments or portfolios with varying risk characteristics, taking into account the opportunity cost of capital. It also encourages diversification and risk reduction, as well as helping you balance your short-term and long-term goals by considering both the expected return and potential volatility of your portfolio.

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'JB' Beckett
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As we head into a period of increasing use of unlisted assets and green infrastructure then RAROC becomes a useful screening metric for the portfolio analyst. The expected return of an asset can be divided by its value at risk (VaR) to arrive at RAROC. For fund analysts this is not dissimilar to a typical risk adjusted ratio such as Sharpe’s but consider that you may not have the historical returns available to perform; so using RAROC allows the use of available data (cash flow, NPV, FV, WACC, short term earnings, valuation, VaR estimates). Eg. A fund that is partially invested in real or unlisted assets such as private markets, infrastructure then your standard vol measures will understate the overall riskiness of the portfolio.

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5 What are the limitations of RAROC?

RAROC is not a perfect measure of portfolio performance, and it has some limitations that you should be aware of. For instance, it relies on assumptions and estimates that may not be accurate or consistent, and it does not capture the non-financial aspects of your portfolio. Furthermore, it does not guarantee that your portfolio will achieve the desired RAROC as there could be unforeseen events or scenarios that could affect your portfolio performance. To ensure you are making the right investments, it is important to adjust assumptions and estimates periodically, consider other criteria or metrics to evaluate non-financial dimensions, and monitor your portfolio regularly to take corrective actions if needed.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What is the best way to use RAROC for evaluating your investment portfolio?

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1 What is RAROC?

2 How to calculate RAROC?

3 How to use RAROC for your portfolio?

4 What are the benefits of RAROC?

5 What are the limitations of RAROC?

6 Here’s what else to consider

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