Question

What is the essential idea underlying Risk - adjusted return on Capital Models and how does this model relate to the concept of duration?

Answer 1

Risk Adjusted Return on Capital

The Risk Adjusted Return on Capital (RAROC) models are used in diverse set of scenarios ranging from evaluating acquisitions, to project finance, to equity and debt investments. The fundamental idea is to evaluate the return of the project after accounting for the risk involved and not the absolute amount.

For ex: Two projects, a thermal power plant and a hospital, theoretically (accounting basis) might give a 20% return on capital invested. But, the risk (credit risk/market risk, etc.) involved in both the projects are totally different. Hence, on a risk adjusted basis, the hospital might give a better Return on Capital as compared to the thermal power plant.

Duration

Duration is a concept which is most commonly associated with the debt investments i.e. where capital deployed is in form of debt. Duration measures the price sensitivity of a bond/debt investment to the change in it's interest rate.

Relation of Duration and RAROC

Concept of 'Duration' is utilized when you calculate the RAROC for a debt investment. The basis formula for RAROC for a debt investment would be as given below:

In this RAROC calculation, the 'Capital at Risk' can be calculated using broadly two methods i.e. theoretical or market based (generic market practice). When you calculated the 'Capital at Risk' usign a market based approach, the concept of duration affects the risk of capital as given below:

The duration affects the 'Capital at Risk calculation and that is how it relates to the RAROC models.