What type of risk does the ARAROC formula account for?

The ARAROC (Adjusted Risk-Adjusted Return on Capital) formula primarily addresses operational risk. This is because the ARAROC framework is designed to evaluate performance by taking into account the risks associated with operations, rather than focusing solely on market movements, credit exposures, or liquidity concerns. Operational risk encompasses various potential failures in processes, people, and systems, and ARAROC seeks to measure how well capital is utilized in light of these risks.

In financial analysis, while market, credit, and liquidity risks are crucial components to consider for comprehensive risk management, ARAROC specifically hones in on the unique challenges posed by operational failures and inefficiencies. This distinction makes ARAROC a valuable tool for institutions looking to optimize their capital while accurately reflecting the risks inherent in their operations.