Risk-Adjusted Performance Measure

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table4"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table5"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table6"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Risk-Adjusted Performance Metric (RAPM)</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table7"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td align="left" valign="top" width="98%"><p class="word_list"> <a href="#RAPM">RAPM</a><p class="word_list"> <a href="#risk-adjustment_performance_metric">risk-adjusted performance metric</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table8"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Performance analysis—both prospective and retrospective—plays an important role in business and investing. Consider some examples:</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">A pension plan has used a particular investment manager to invest its assets for the past five years. They want to perform a retrospective assessment of his performance to determine whether they should keep him for the next five years or replace him with a new manager. Their performance assessment must look at both the <a href="../articles/return.htm">returns</a> he has earned for them over the past five years but also the <a href="../articles/risk.htm">risks</a> he has taken to earn those returns.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">A corporation has several business lines it can invest in, but limited resources prevent it from investing in them all. The firm will choose what mix of business lines to invest in based on a prospective assessment of profitability and risk.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">An investor is allocating her assets to various asset classes—domestic <a href="../articles/common_stock.htm">equities</a>, foreign equities, <a href="../articles/junk_bond.htm">investment-grade bonds</a>, <a href="../articles/junk_bond.htm">junk bonds</a>, etc. She chooses an asset allocation based on a prospective assessment of expected returns and risk.</p> <p class="body">Such assessments must take risk into account. Since a portfolio manager can boost expected returns merely by increasing his <a href="../articles/capital_asset_pricing_model.htm">systematic risk</a> (<a href="../articles/beta.htm">beta</a>), performance evaluations must adjust returns for risk. All else being equal, a firm would rather invest in a low-risk business line than one that is equally profitable but more risky. And, obviously, an investor allocating her assets must balance risk against expected returns.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table9"> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">Stated another way, any performance assessment should balance risk against reward. That is what a <b> <a name="risk-adjustment_performance_metric">risk-adjustment performance metric</a></b> (<b><a name="RAPM">RAPM</a></b>) does. A RAPM is a performance <a href="../articles/risk_metric_and_risk_measure.htm"> metric</a> that assesses reward with some adjustment for the risks taken to achieve that reward. What we mean by reward depends on the application. It might be revenues, profits, returns, etc. Similarly, risk might be measured as <a href="../articles/volatility.htm"> volatility</a>, beta, <a href="../articles/value_at_risk.htm"> value-at-risk</a>, etc.</p> <p class="body">Various RAPMs are employed in finance. Some were developed during the late 1960s for testing the <a href="../articles/efficient_market_hypothesis.htm">efficient market hypothesis</a> and are now used by practitioners for asset allocation or performance assessment. These include the <a href="../articles/sharpe_ratio.htm">Treynor ratio</a>, the <a href="../articles/sharpe_ratio.htm">Sharpe ratio</a> and <a href="../articles/alpha.htm"> Jensen's alpha</a>. Other RAPMs—including <a href="../articles/economic_capital.htm">ROC</a> and its various <a href="../articles/economic_capital.htm">RAROC</a> interpretations—were developed during the 1980s and 1990s to support <a href="../articles/economic_capital.htm">economic capital</a> allocation.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table12"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/capital_allocation.htm">capital</a> A firm's value—assets minus liabilities.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/economic_capital.htm">economic capital</a> </strong> Capital held for economic (as opposed to regulatory) purposes.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_3.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Forum Discussions</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table13"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><b><a target="_top" href="http://www.riskarchive.com/link_thread/97-3/00000064.htm">VAR as a RAPM</a></b> <i>01 Aug 1997</i><br> The relative merits of return on capital and economic profit as RAPMs.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><b><a target="_top" href="http://www.riskarchive.com/link_thread/97-1/00000016.htm">Leverage Adjusted Performance</a></b> <i>31 Dec 1996</i><br> Performance measurement of leveraged vs. unleveraged portfolios.</td> </tr> </table> </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table14"> <tr> <td width="100%" bgcolor="#FFFFFF"> <p align="center" style="margin-top: 18"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com"> http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 2007<p align="center"><map name="FPMap1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1" width="241" height="89"></td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div> </body>