Risk-adjusted performance measurement is a fundamental tool for financial institutions in business selection, risk pricing, and performance evaluation. The existing RORAC (such as, Sharpe Ratio), when combined with risk capital allocation, faces limitations in practical application due to its instability and subjectivity. Dr. Chen Ermo, a Boya Postdoctoral Fellow at the Institute for Global Health and Development of Peking University, and Professor Wu Lan from the School of Mathematical Sciences at Peking University, who was Dr. Chen's doctoral supervisor, conducted fundamental theoretical research addressing this issue. They discovered that by leveraging the concept of risk capital cost savings from capital allocation, it is possible to connect the public capital market with an institution's internal risk capital market, resulting in a robust, market-adaptive risk-adjusted performance measure. This research, titled "mRORAC: A stable and market adapted risk-adjusted performance measure for capital allocation," has been published online in  International Review of Financial Analysis  (IRFA), a top-tier finance journal with a composite impact factor of 9.8.

Figure 1: The paper published online in International Review of Financial Analysis

By utilizing the concept of risk capital cost savings achieved through risk capital allocation, the paper theoretically proposes a new risk-adjusted performance measure, mRORAC.

The research demonstrates that compared to traditional RORAC measures, mRORAC possesses significantly superior stability without compromising risk sensitivity. Furthermore, mRORAC exhibits desirable properties in allocation monotonicity and risk diversification that RORAC lacks.

Figure 2: The properties of mRORAC

The study provides the economic theoretical foundation for mRORAC. mRORAC can induce a class of Economic Value Added (EVA) maximization problems with an endogenous capital cost rate. It unifies the EVA maximization problem with a subjective capital cost rate (associated with RORAC) and the maximum risk-return portfolio problem (associated with the Capital Asset Pricing Model, CAPM), thereby achieving simultaneous equilibrium in both the public capital market and the institution's internal risk capital market.

Figure 3: Tail behavior of mRORAC compared to RORAC

Both simulation analysis and empirical analysis verify the stability and market adaptability of mRORAC.

* Note: mRORAC was proposed by Dr. Chen Ermo in 2018 as a risk-adjusted performance measure based on financial risk management practice. This paper provides the theoretical support for its superior performance observed in practice.

Author Profiles:

Chen Ermo is a Boya Postdoctoral Fellow at the National School of Development / Institute for Global Health and Development at Peking University. He holds a B.Sc. and a Ph.D. in Science from Peking University. Dr. Chen is the Chief Scientist for the Planetary Health Axis System (PHAS) project at the Institute for Global Health and Development at Peking University. He graduated from the School of Mathematical Sciences at Peking University with a Ph.D. in Science. His previous positions include actuary of the Actuarial Department at China Reinsurance Corporation Group, and Risk Control Director, Chief Data Scientist, and Senior Risk Advisor at the Aden Technology. Dr. Chen's main research interests include risk capital measurement and allocation, uncertainty measurement and decision-making in complex systems, health technology effectiveness evaluation, and planetary health metrics. He has led/participated in numerous vertical/horizontal projects in the fields of risk management and global health. Dr. Chen is the originator of the modified Return on Risk Adjusted Capital (mRORAC). He received the China Health Insurance Technology Innovation Award in 2019 and the Best Health Insurance Technology Innovation Award in 2020. He was the actuary for China's first weather-health index insurance product.

Professor Wu Lan is a Professor and Doctoral Supervisor at the School of Mathematical Sciences, Peking University, where she has long been engaged in teaching and research in financial mathematics and actuarial science. She began teaching at Peking University in 1990 and obtained her Ph.D. in Science from Peking University in 1999. Professor Wu has presided over multiple national-level research projects, including the National Ministry of Science and Technology's 973 Program project "Quantitative Analysis and Computation in Financial Risk Control." She currently serves as the Director of the Department of Financial Mathematics at the School of Mathematical Sciences, Peking University, and has achieved a number of academic results in insurance actuarial science, financial mathematics, and financial statistics. She also serves as an independent director for commercial banks, insurance companies, and fund management companies.