Economic value of equity

Economic value of equity is the present value of all overall assets minus present value of all liabilities. It is commonly used by banks as an instrument of interest rate risk management.

Δ(economic value) = Δ(value of assets) - Δ(value of deposits)

EVE supports banks to appraise the influence of interest rate risk on net worth and equity of the bank because the value of assets and liabilities of a bank are throughtly linked with the interest rates. The values of the assets and liabilities are not the accounting or book values. The values of the assets and liabilities are not the accounting or book values. This is an economic concept that evaluate s the influence of interest rate changes on fair market values of asset, liabilities, and equity.

EVE captures the change in economic value of the bank even though that modification may not be imaged in the bank's accounting books and records. Consider the underlying market value of bonds in the investment portfolio. We all know that if interest rates rise, bond prices fall. This is the manifestation of price risk. What is not as clear, however, is the degree to which that modification in the economic value of the investment portfolio value will influence the overall value of the balance sheet. Note that loans also have a theoretical economic value just like bonds. If market interest rates rise sharply, then existing fixed rate loans will be worth less from an economic point of view.

Fig.1. Economic value of equity (EVE) calculation process

How do we calculate Economic Value of Equity?

If we can count the fair market value of assets and liabilities, then we can readily back into the value of equity capital. Furthermore, if we can project the changed value of assets and liabilities under different rate environments, we can measure projected changes in EVE as well. This is accurately what we do when we measure interest rate risk from the economic perspective.

Surveillance modification in the Economic Value of Equity is worthwhile in that it supplies a comprehensive measurement of interest rate risk. It captures the effects of possibility and other significant influences on value that are not contained in static accounting type reports. The economic valuation tactic also reflects those sensitivities across the full mellowness spectrum of the bank's assets and liabilities.

Advantages of EVE

For all its advantages, Economic Value of Equity also suffers from a number of disadvantages. For instance, the sensitivity of the Economic Value of Equity to changes in interest rates gives no information about the exact timing of rate risk. Managers need to know IRR timing as well as the quantity. Risk exposures may exist in the next 12 months, but may be entirely different over the subsequent two years. EVE simply shocks the balance sheet instantaneously and calculates overall valueKatKrisk. Another downside is the fact that EVE consist inmethodological and calculation presumptionwhich may or may not turn out to be precise.

The most brilliant of these is the discount rate assumptions that are used to calculate the present value of assets and liabilities. It is relatively easy to count the market value of a bond with a fixed rate of interest and a fixed maturity. It is considerably more difficult and far less aim to count the economic value of a saving account with no fixed maturity and an administered rate that is subject to change by bank management.

Measurement interest rate risk involves tracking energetic and composed relations within a bank's balance sheet. To do it accordingly, we must have good contribution, reasonable assumptions, and sound methodology. The estimate and monitoring of changes in the economic value of equity is a significant part of the process. And in the last analysis, we cannot correctly manage the financial risk of our bank without a clear understanding of these measurements.

EVE

Economic value of equity:

1. is helpful for calculating actual risk as a going concern.
2. makes it possible bankers to visualize what can happen in a season of interest rate volatility causing important deposit withdrawals and loss of earnings.
3. has more worth than a shorthold instrument such as NII which falls short in giving bankers insight to proactively respond to detrimental market developments.

This is why the Basel Committee on Banking Supervision recommends a plus and minus 2% stress test on all interest rates and why US bank regulations require regular analysis of EVE.

Examples of Economic value of equity

• Economic value of equity is a metric used to assess the financial performance of a company. It is calculated by subtracting the market value of all liabilities from the market value of all assets. This metric is most commonly used by banks and other financial institutions to identify the risk associated with their investments.
• Economic value of equity can also be used to assess the performance of a firm's stock. For instance, if a company's stock price is increasing and its economic value of equity is also increasing, this may be an indication that the company's stock is undervalued. Conversely, if the company's stock price is declining and its economic value of equity is decreasing, this may be an indication that the stock is overvalued.
• Economic value of equity can also be used to compare the performance of different companies. For example, if two companies are in the same industry and one has a higher economic value of equity than the other, this may be an indication that the first company is performing better than the second.

Limitations of Economic value of equity

The economic value of equity has some limitations that must be taken into account when using it as an instrument of interest rate risk management. These include:

• The value of equity is subject to change due to market fluctuations, making it difficult to accurately determine the current value.
• It does not take into account the cost of capital or the cost of financing, which can influence the overall return on equity.
• It does not consider the potential for growth, making it difficult to project future returns.
• It is not accounting for the risk associated with investments, which can also affect returns.
• It does not consider the impact of taxes, which can also have an effect on return.
• It is based on historical data, which may not capture potential future changes in the market.

Overall, the economic value of equity can be a useful tool for interest rate risk management, but it is important to take into account its limitations when making decisions.

Other approaches related to Economic value of equity

The Economic Value of Equity (EVE) is a measure of the intrinsic value of a company or other asset, usually expressed in monetary terms. However, it is important to note that there are a variety of approaches to calculating EVE, each with its own advantages and disadvantages. These approaches include:

• Discounted Cash Flow (DCF) Analysis: This approach calculates EVE by taking the present value of all future expected cash flows. This method is considered one of the most reliable ways to measure EVE, as it takes into account all future cash flows, including taxes and other costs.
• Economic Value Added (EVA): This approach is based on the idea that a company's value is determined by its ability to generate a return on capital that exceeds the cost of capital. It is calculated by subtracting the cost of capital from the return on capital.
• Relative Valuation: This approach uses the prices of similar companies in the same industry to calculate the value of a given company. It is based on the idea that a company should be worth more or less than similar companies.
• Dividend Discount Model: This approach uses the dividend payments made by a company to calculate its EVE. It assumes that the dividends paid by a company are equal to the EVE of the company.

In summary, there are a variety of approaches to calculate the Economic Value of Equity, each with its own advantages and disadvantages. The most commonly used methods are DCF Analysis, EVA, Relative Valuation and the Dividend Discount Model.

Economic value of equity — recommended articles

Running yield — WACC — Market Risk Premium — Gordon Growth Model — Annualized rate — Calmar Ratio — Book profit — Simple rate of return — Earnings Multiplier

References

• Berglund,A. (2017). On the risk relation betweenEconomic Value of Equity and NetInterest Income, On the risk relation betweenEconomic Value of Equity and NetInterest Income
• Georgiev G.P, (2016), Interest Rate Risk Management Using Economic Value Sensitivity Model , Interest Rate Risk Management Using Economic Value Sensitivity Model
• Gregory E. Sierra and Timothy J. Yeager,(2004)What Does the Federal Reserve’s Economic Value Model Tell Us About Interest Rate Risk at U.S. Community Banks?. What Does the Federal Reserve’s Economic Value Model Tell Us About Interest Rate Risk at U.S. Community Banks?

Author: Beata Furmanek