Short description
Have you been in a situation where you have two investment options one with a rate of 9% and risk grade B and another with a rate of 12% and a rating C and you are wondering which one to choose? If so this video is for you! In this video, we will explain how to calculate actual returns on loan investments that are adjusted by a potential loss as Banks do it. RORAC - Return on Risk-Adjusted Capital.
RORAC Calculator: https://blog.crowdinform.com/articles/calculator/
PD Data:https://blog.crowdinform.com/uploads/PD-europe-23.pdf
Hello, everyone!
Have you been in a situation where you have two investment options one with a rate of 9% and risk grade B and another with a rate of 12% and a rating C and you are wondering which one to choose?
If so this video is for you!
To compare loans with different risk grades and rates you need to know what is RORAC or Return on Risk-Adjusted Capital and how to calculate it.
Let’s have an example of what it means - You have invested 100 EUR in 100 loans or 10 thousand in total, with maturity 1 year with a rate of 10% p.a.
After one year 98 loans were successfully repaid and for two you got nothing they when defaulted, which means - you got 9800 as principal + 10% for this amount which is 980 so in total you got back 10780 EUR so your profit is 780 EUR or 7.8% not 10%.
RORAC formula helps you to calculate these estimated returns before investing, but to do so you need an answer to 2 questions.
What is the probability that the borrower will default?
And if he goes default how much money I will lose?
To answer the first question you need to know so called probability of default or PD for short. PD is calculated by credit organizations, by looking at last year's all borrower's performance, dividing them into risk groups, and seeing how much in each group has defaulted. So in simple words, if 2% of borrowers from group A have defaulted it means that grade A has a Probability of default of 2% this year, meaning if you will invest in 100 loans with rating A 2 of them will default.
And that is what Ratings in lending suppose to represent.
Currently, most platforms in rating are providing several facts like the quality of management, financial standing, etc. but not a conclusion of all those facts.
Likely European crowdfunding regulation set a requirement that licensed crowdfunding platforms have to provide PD and this is great so you will be able to understand it easily.
If the platform is not providing PD, you could look for public sources like average small and medium default rates in a particular country it is not ideal but it will give you an indication of potential loss.
The second question is how much money you will lose if the borrower will default.
If your loan is secured by some asset, let’s say real estate and the borrower defaults, this property will be sold, and sells price will be used to repay your loan so you might lose only a proportion of lend money or even nothing.
For the purpose of the RoRAC calculation, you need to understand what is Loss given default -in simple words it shows an estimation of how much funds you will lose if the company goes bankrupt.
Let’s say the total loan is 1 million and the security value is 1.3 million so it is most likely that you will get all your money, but keep in mind if you try to sell fast you most likely sell below market price, and sales costs might be a few percent from sales price.
Let’s sum up.
When investing at some point you will lose some money I mean biggest banks, cities, and even countries default. And that is fine since if you understand the risk-reward ratio you will choose investments that even if some of them go default you still will be making good returns.
There is a saying “There is no bad risk just a bad price”
We in cooperation with our friends from the auditor company Vilson have Prepared a RORAC calculator so you can easier understand what investments to choose.
Rorac calculator and more tools and information to make better investments in alternative investments you will find on crowdinform.com
And if you have any questions let us know in the comments below.
It is for now!
We wish you a good day and successful investing!
