Risk adjusted returns vs Sharpe ratio

Discussion in 'SP9' started by Edwin, Aug 12, 2014.

  1. Edwin

    Edwin Member

    April 2011 q 6 (ii) speaks of calculating RAROE, the formula in the examiner's report does this by;

    RAROE = (Pre-dividend net of tax profits adjusted for risk based
    losses minus mean risk cost minus risk free rate of return)/shareholders’ equity

    ASET on the other hand (also see Q&A 5.20 on RAROC) shows the result as;-

    RAROE = (Revenues - costs - expected Losses + Return on risk capital - taxes)/Shareholder equity

    I dont understand the approach of ACED Tutors of adding the Return on risk Capital (ASET says this is equivalent to the average risk free rate)

    In conventional risk adjusted measures e.g the Sharpe ratio, the risk free rate is subtracted from the return on an asset. Does anyone know why ACTED is adding?
     
  2. Simon James

    Simon James ActEd Tutor Staff Member

    Hi

    The question asks how a risk-adjusted performance measure could be constructed to compare different listed companies.

    There is no one right answer and the examiners would have accepted a variety of approaches. We took a slightly different tack from the examiners.

    We used a Bankers Trust* RAROC type measure which explicitly allows for the return on risk capital. (In practice this return may already effectively be included in the "revenue" if using published accounts)

    Note that the Sharpe measure is doing something slightly different - it is looking at return on an investment portfolio over the risk-free rate is commensurate with the risk taken.

    Here, we are looking at the returns net of risk. As long as the approach is consistent between companies it doesn't really matter if we deduct the risk-free return or not.

    * google for more info!
     

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