RAROC

RAROC estimates probability of a firm’s profits on its investment, and RAROC also adds expected risks rates into calculation, so RAROC could measure more realistic value. There are three basic risks, and those are market risk, credit risk, and operational risk. RAROC is an upgrade version of ROC since ROC measures without adding expected risk rates into calculation. RAROC was developed by Bankers Trust in 1970. The main purpose of the RAROC is to set optimal amount of capital to hold while a firm is investing in a new project. There are two reasons RAROC to allocates capital, the one is risk management, and the other is evaluation. RAROC is calculated by expected return divided by economic capital. The economic capital is similar as VAR. It measures the amount of capital a firm needs in the worst situation. Economic capital is little different from regulatory capital. The regulatory capital is the minimum amount of money, which regulators require to have. However, economic capital the amount of money for companies’ the worst case scenarios.
I think it is very hard to expect those three risks, market risk, credit risk, and operational risk, also hard to average and compare those tree risks. The reason is that equality of certain value of market risk is different from credit risk, and operational risk. For example, if market risk is 2, we do not know whether the value, 2, of market risk works same in the credit risk or operational risk. I think to increase accuracy of RAROC, we need to focus on accuracy the three value of risks to be reasonable and acceptable.


http://www.riskglossary.com/link/economic_capital.htm

http://www.12manage.com/methods_raroc_ko.html