Economic Value of Equity (EVE): Protection against rising rates of interest

In view of rampant inflation, central banks around the globe are raising rates of interest. The US Federal Reserve announced in June the biggest migration since 1994. In the previous month, the Bank of England (BOE) had pushed British rates of interest to a 13-year high. The central banks of Brazil, CanadaAnd Australia also hiked, and the European Central Bank (ECB) plans to follow suit later this month.

Such rate of interest hikes not only cause turmoil in risk markets; They may also jeopardize an organization’s financial stability.

The devil is in the main points in terms of quantifying how these increases will impact an organization’s bottom line. Beyond the plain impact on financing costs, capturing the impact on economic value requires a more strategic and holistic approach.

As we show here, the effect varies depending on how heavy and energetic the corporate’s assets and liabilities are. The calculation becomes much more complex for financial or investment firms that juggle multiple balance sheets at the identical time. Still, financial risk management and market risk hedging are critical to the success of any business, so analysts must understand the tools available.

Economic Value of Equity (EVE)

The economic value of equity (EVE) or net value defines the difference between assets and liabilities in keeping with their respective market values. EVE represents the income or losses that an organization must incur in the course of the chosen horizon or timeframe. Therefore, EVE reflects how assets and liabilities would reply to changes in rates of interest.

EVE is a well-liked metric utilized in the Interest rate risk within the banking book (IRRBB) calculations, and banks often use this to measure the IRRBB. But EVE may also help firms – and the analysts who serve them – calculate the chance to their dynamic assets and liabilities.

The metric deals with the money flow calculation resulting from netting the current value of expected money flows on liabilities or the market value of liabilities (MVL) with the current value of all expected money flows on assets or the market value of assets (MVA).

While EVE is crucial as a static number, how EVE would behave also matters to the health of an organization change for every unit of rate of interest movement. So to calculate the change in EVE we take the delta (D) the market values ​​for each assets and liabilities. That is, DEVE = DMVA – DMVL.

The fantastic thing about this measurement is that it quantifies the ΔEVE for any chosen timeframe and allows us to create as many alternative time periods as we’d like. The table below shows the changes in EVE of a hypothetical company assuming a parallel 1 basis point increase in rates of interest.

What is an appropriate EVE?

Economic intuition tells us that long-term assets and liabilities are more prone to changes in rates of interest because of their stickiness and subsequently are usually not subject to re-fixing within the short term. In the chart above, the online change in EVE is -$3,032,194 for each one basis point increase along the yield curve, and now we have the granularity needed to find out the areas where the corporate is most vulnerable.

How can an organization close this gap? What is the optimal allocation between the maturity/amounts of assets and liabilities? First, each institution has its own optimal allocation. One size doesn’t fit all. Each company’s risk profile and preset risk appetite determine the optimal EVE. Asset and Liability Management (ALM) is undoubtedly an art: it helps translate the corporate’s risk profile into reality.

Because EVE is primarily a long-term metric, it may be volatile with changes in rates of interest. This requires applying best market practices when applying a stress technique equivalent to Value at Risk (VaR), which helps to grasp and predict future rate of interest movements.

On and off the balance sheet

An organization can manage the EVE gap between assets and liabilities – and associated risk mitigation practices – either on the balance sheet or off the balance sheet. An example of accounting hedging is when an organization simply obtains fixed-rate financing relatively than tying it to a floating index equivalent to US LIBOR or issuing a fixed-rate bond to normalize the duration gap between assets and liabilities.

Off-balance sheet hedging maintains the discrepancy between assets and liabilities but uses financial derivatives to synthetically achieve the specified result. With this approach, many firms use vanilla rate of interest swaps (IRS) or derivatives with rate of interest caps.

Details of the balance sheet gap are usually not at all times visible when reviewing the annual financial statements. However, decision makers and investors have to concentrate and be vigilant because the EVE metric captures the market value of the cumulative money flows for the approaching years. And as we showed above, the calculation is straightforward.

A security valve for an uncertain future

With a bit of due diligence, we will higher understand how an organization manages its rate of interest risk and associated ALM processes. Although banks and huge financial institutions use the EVE indicator extensively, other firms should too. And analysts should do the identical.

When an organization sets limits on risk, monitors it and understands the associated changes in value because of rate of interest movements and their impact on its financial position, it creates a security valve that protects against market risk and the uncertain rate of interest outlook.

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Photo credit: ©Getty Images/Heiko Küverling