What is Risk-Adjusted Return on Capital ?

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Risk-adjusted return on capital (RAROC) is a modified return on investment (ROI) figure that takes elements of risk into account. In financial analysis, projects and investments with greater risk levels must be evaluated differently; RAROC thus accounts for changes in an investment’s profile by discounting risky cash flows against less-risky cash flows.

Definition

Risk-Adjusted Return on Capital (RAROC) is a modified version of the return on investment (ROI) metric that takes risk factors into account. In financial analysis, projects and investments with higher risk levels must be evaluated differently; thus, RAROC adjusts for high-risk cash flows by discounting them relative to low-risk cash flows.

Origin

The concept of RAROC originated in the 1980s, developed by banks and financial institutions to better assess and manage risk. As financial markets became more complex, traditional ROI could not adequately reflect risk factors, leading to the development of RAROC.

Categories and Features

RAROC is mainly divided into two categories: RAROC based on economic capital and RAROC based on regulatory capital. Economic capital-based RAROC considers internal risk management strategies, while regulatory capital-based RAROC complies with external regulatory requirements. Both emphasize the balance between risk and return, but their application scenarios and calculation methods differ slightly.

Case Studies

Case 1: A bank, when evaluating a high-risk loan, uses RAROC to determine its risk-adjusted return. Through calculation, the bank finds that the loan's RAROC is below its internal benchmark, leading to a decision not to approve it. Case 2: An insurance company, when assessing its investment portfolio, uses RAROC to adjust the risk-return of different assets. Through RAROC analysis, the company reallocates assets to enhance the overall risk-adjusted return of the portfolio.

Common Issues

Common issues investors face when using RAROC include misjudging risk and incorrectly discounting cash flows. Misunderstanding risk levels can lead to poor investment decisions, while inaccurate discount rates can affect the accuracy of RAROC.

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Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term financial obligations due to an inability to convert assets into cash without incurring a substantial loss. This risk is inherent in both financial institutions and corporations, significantly impacting their operational and financial stability.Liquidity risk is often characterized by two main aspects: market liquidity risk and funding liquidity risk. Market liquidity risk is associated with an entity's inability to execute transactions at prevailing market prices due to insufficient market depth or disruptions. On the other hand, funding liquidity risk pertains to the inability to obtain sufficient funding to meet financial obligations.Liquidity risk is not confined to any particular sector, as it is an important consideration across banks, financial institutions, corporations, and even some individual investors. For banks and financial institutions, liquidity risk management is underscored by regulatory frameworks that mandate certain liquidity standards to ensure financial stability and protect depositor interests. Corporations, too, need to be vigilant in managing liquidity risk to ensure they have adequate cash or credit lines to meet their operational and financial commitments. The ability to manage liquidity risk is essential for ensuring it has enough cash on hand to meet its short term needs and obligations.

Liquidity Risk

Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term financial obligations due to an inability to convert assets into cash without incurring a substantial loss. This risk is inherent in both financial institutions and corporations, significantly impacting their operational and financial stability.Liquidity risk is often characterized by two main aspects: market liquidity risk and funding liquidity risk. Market liquidity risk is associated with an entity's inability to execute transactions at prevailing market prices due to insufficient market depth or disruptions. On the other hand, funding liquidity risk pertains to the inability to obtain sufficient funding to meet financial obligations.Liquidity risk is not confined to any particular sector, as it is an important consideration across banks, financial institutions, corporations, and even some individual investors. For banks and financial institutions, liquidity risk management is underscored by regulatory frameworks that mandate certain liquidity standards to ensure financial stability and protect depositor interests. Corporations, too, need to be vigilant in managing liquidity risk to ensure they have adequate cash or credit lines to meet their operational and financial commitments. The ability to manage liquidity risk is essential for ensuring it has enough cash on hand to meet its short term needs and obligations.

Zero-Proof Bookkeeping

Zero-proof bookkeeping is a manual bookkeeping procedure used in accounting in which posted entries are systematically subtracted from an ending balance to check for errors. In zero-proof bookkeeping, a balance of zero when all entries have been subtracted is proof that the accounting entries have been entered correctly. In this way, this practice is quite similar to keeping a balance sheet, which is a common financial statement issued by firms that balances assets with liabilities and shareholder's equity - such that subtracting the left side from the right side of the balance sheet results in a sum of zero.Zero-proof bookkeeping is employed as part of a double-entry bookkeeping system, where credits (liabilities) and debits (assets) are kept track of simultaneously.

Zero-Proof Bookkeeping

Zero-proof bookkeeping is a manual bookkeeping procedure used in accounting in which posted entries are systematically subtracted from an ending balance to check for errors. In zero-proof bookkeeping, a balance of zero when all entries have been subtracted is proof that the accounting entries have been entered correctly. In this way, this practice is quite similar to keeping a balance sheet, which is a common financial statement issued by firms that balances assets with liabilities and shareholder's equity - such that subtracting the left side from the right side of the balance sheet results in a sum of zero.Zero-proof bookkeeping is employed as part of a double-entry bookkeeping system, where credits (liabilities) and debits (assets) are kept track of simultaneously.

Zero-Gap Condition

A zero-gap condition exists when a financial institution's interest-rate-sensitive assets and liabilities are in perfect balance for a given maturity. The condition derives its name from the fact that the duration gap—or the difference in the sensitivity of an institution's assets and liabilities to changes in interest rates—is exactly zero. Under this condition, a change in interest rates will not create any surplus or shortfall for the company, since the firm is immunized to its interest rate risk for a given maturity.

Zero-Gap Condition

A zero-gap condition exists when a financial institution's interest-rate-sensitive assets and liabilities are in perfect balance for a given maturity. The condition derives its name from the fact that the duration gap—or the difference in the sensitivity of an institution's assets and liabilities to changes in interest rates—is exactly zero. Under this condition, a change in interest rates will not create any surplus or shortfall for the company, since the firm is immunized to its interest rate risk for a given maturity.

Like-Kind Exchange

A like-kind exchange is a tax-deferred transaction that allows for the disposal of an asset and the acquisition of another similar asset without generating a capital gains tax liability from the sale of the first asset.Until the passage of tax legislation in December 2017, that could have included the exchange of one business for another—or one piece of tangible property, such as artwork or heavy equipment, for another. After 2017, a like-kind exchange applies only to the exchange of a business or real estate investment property for another property.

Like-Kind Exchange

A like-kind exchange is a tax-deferred transaction that allows for the disposal of an asset and the acquisition of another similar asset without generating a capital gains tax liability from the sale of the first asset.Until the passage of tax legislation in December 2017, that could have included the exchange of one business for another—or one piece of tangible property, such as artwork or heavy equipment, for another. After 2017, a like-kind exchange applies only to the exchange of a business or real estate investment property for another property.

Identifiable Asset

An identifiable asset is an asset whose commercial or fair value can be measured at a given point in time, and which is expected to provide a future benefit to the company. These assets are an important consideration in the context of mergers and acquisitions.Because not all assets on a company's balance sheet are able to be quickly and accurately valued at a point in time, only those which are may be classified as identifiable. Examples include cash, short-term liquid investments, property, inventories, and equipment, among others.Identifiable assets may be contrasted with goodwill.

Identifiable Asset

An identifiable asset is an asset whose commercial or fair value can be measured at a given point in time, and which is expected to provide a future benefit to the company. These assets are an important consideration in the context of mergers and acquisitions.Because not all assets on a company's balance sheet are able to be quickly and accurately valued at a point in time, only those which are may be classified as identifiable. Examples include cash, short-term liquid investments, property, inventories, and equipment, among others.Identifiable assets may be contrasted with goodwill.

Equity Multiplier

The term equity multiplier refers to a risk indicator that measures the portion of a company’s assets that is financed by shareholders' equity rather than by debt. The equity multiplier is calculated by dividing a company's total asset value by the total equity held in the company's stock. A high equity multiplier indicates that a company is using a high amount of debt to finance its assets. A low equity multiplier means that the company has less reliance on debt. The equity multiplier is also known as the leverage ratio or financial leverage ratio and is one of three ratios used in the DuPont analysis.

Equity Multiplier

The term equity multiplier refers to a risk indicator that measures the portion of a company’s assets that is financed by shareholders' equity rather than by debt. The equity multiplier is calculated by dividing a company's total asset value by the total equity held in the company's stock. A high equity multiplier indicates that a company is using a high amount of debt to finance its assets. A low equity multiplier means that the company has less reliance on debt. The equity multiplier is also known as the leverage ratio or financial leverage ratio and is one of three ratios used in the DuPont analysis.