Potential risks that a company faces can be analyzed in many ways. Earnings at risk (EAR), value at risk (VAR), and economic value of equity (EVE) are among the most common and each measure is used to assess potential value changes within a specified period. They are particularly important to companies or investors in companies that operate internationally. That's because, while most companies face interest rate risk, companies that operate abroad deal with multiple interest rate risks.

Earnings at Risk

Earnings at risk is the amount of change in net income due to changes in interest rates over a specified period. It 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.

Key Takeaways

  • Investors can measure risk in many different ways including earnings at risk (EAR), value at risk (VAR), and economic value of equity (EVE).
  • Earnings at risk is the amount that net income may change due to a change in interest rates over a specified period.
  • Value at risk is a statistic that measures and quantifies the level of risk within a firm, portfolio, or position over a specific time period.
  • Value of equity is used to manage a bank's assets and represents the level of exposure to interest rate risk.

EAR calculation includes balance sheet items that are considered sensitive to changes in interest rates and generate income or expense cash flows. For example, a bank may have 95% confidence that the deviation from expected earnings due to changes in interest rates will not exceed a certain number of dollars throughout a certain period. This is its earnings at risk.

Value at Risk

Value at risk measures the overall change in value over a specified period within a certain degree of confidence. It measures the financial risk associated with a firm's total value, which is a far broader issue than the interest rate risk to its cash flow. The value at risk model measures the amount of maximum potential loss over a specified period.

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

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. This is a long-term economic measure used to assess the degree of exposure to interest rate risk. Unlike earnings at risk and value at risk, a bank uses the value of equity measure to manage its assets and liabilities.

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.