The potential risks that face a company or an investment asset are analyzed in many different ways. Three of the most common ways to assess risk are called earnings at risk (EaR), value at risk (VaR), and economic value of equity (EVE).
All are measures used to assess potential value changes within a specified period:
- Earnings at risk assesses the amount that net income may change due to a change in interest rates over a specified period.
- Value at risk measures the overall change in value over a specified period within a certain degree of confidence.
- Economic value of equity is primarily used in banking and measures the amount that a bank's total capital may change due to interest rate fluctuations.
Who Uses Them
These measures are particularly important to companies or investors in companies that operate internationally. Most companies face some interest rate risk, but companies that operate abroad deal with multiple interest rate risks.
The earnings at risk measure helps investors and risk professionals understand the impact that a change in interest rates can make on a company's financial position and cash flow.
An Example of Earnings at Risk
For example, a bank may have 95% confidence that the deviation from expected earnings will not exceed a certain number of dollars throughout a certain period. This is its earnings at risk.
The value at risk measures the amount of maximum potential loss within a specified period with a degree of confidence. The measure indicates the degree of confidence that a company's losses will not exceed a certain amount of dollars over a specified period.
An Example of Value at Risk
For example, a risk manager determines that a company has a 5% one-year value at risk of $10 million. This value indicates that there is a 5% chance that the firm could lose more than $10 million in a year. Given a 95% confidence interval, the maximum loss should not exceed $10 million over one year.
Value of Equity
Unlike earnings at risk and value at risk, a bank uses economic value of equity to manage its assets and liabilities. This is a long-term economic measure used to assess the degree of interest rate risk exposure.
Economic value of equity is a cash flow calculation that subtracts the present value of the expected cash flows on liabilities from the present value of all expected asset cash flows.
This value is used as an estimate of total capital when evaluating the sensitivity of total capital to fluctuations in interest rates. A bank may use this measure to create models that indicate how interest rate changes will affect its total capital.