RORAC

A rate of return used in financial analysis, whereby riskier

projects and investments are evaluated based on the capital at risk.

Capital is adjusted for a maximum potential loss based on

the probability of future returns

All business organizations attempt to maximize the return

to the shareholders, but the risk taken should be reflected in returns

Mostly used in banks and financial institutions

Formula
RORAC =

Expected Return Economic Capital OR

RORAC = Expected Return

Value At Risk

Economic Capital
The amount of risk capital that an entity estimates in order

to remain solvent at a given confidence level and time horizon.

The amount of capital the firm should have to support any

risks it takes on

Value at Risk
Value at risk can be defined as the worst loss that might

be expected from holding a security or portfolio over a given period of time

A single number that is related to the maximum loss that

might be incurred on a position, at a given confidence level

Example
Assume that an investor has EUR 1,000 to invest. The investment horizon is one year, after which the investor will sell the position. Two investment options are available: Equity 1 and Equity 2. Investment Options Annual return Equity 1 4% Equity 2 10%

Expected Income

40

100

Risk

2%

20%

Economic capital

20

200

Return on risk adjusted capital

(40/20 )* 100= 200%

(100/200 )* 100= 50%

Advantages and Disadvantages

Advantages: it covers Market risk Credit risk Operational risk

Disadvantages: does not cover Systemic risk

Bibliography
Risk Management - Crouhy

Essentials Of Risk Management Crouhy, Galai, Mark

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