Economic Value of Equity (EVE)
What Is the Economic Value of Equity (EVE)?
The economic value of equity (EVE) is a cash flow calculation that takes the current value of all asset cash flows and deducts the current value of all liability cash flows. In contrast to earnings at risk and value at risk (VAR), a bank utilizes the economic value of equity to deal with its assets and liabilities. This is a long-term economic measure used to survey the degree of interest rate risk exposure — rather than net-interest income (NII), which reflects short-term interest rate risk.
The least difficult definition of EVE is the net present value (NPV) of a bank's balance sheet's cash flows. This calculation is utilized for asset-liability management to measure changes in the economic value of the bank.
EVE risk is defined as a bank's value sensitivity to changes in market rates.
Grasping EVE
The economic value of equity is a cash flow calculation that deducts the current value of the expected cash flows on liabilities from the current value of all expected asset cash flows. This value is utilized as an estimate of total capital while assessing the sensitivity of total capital to vacillations in interest rates. A bank might utilize this measure to make models that demonstrate what interest rate changes will mean for its total capital.
The fair market values of a bank's assets and liabilities are directly linked to interest rates. A bank develops models with every constituent asset and liabilities that show the effect of various interest rate changes on its total capital. This risk analysis is a key instrument that permits banks to prepare against continually changing interest rates and to perform stress tests.
A globally accepted standard for determining interest rate risk is to stress-test EVE. The Basel Committee on Banking Supervision suggests a plus and minus 2% stress test on all interest rates and US bank regulations require customary analysis of EVE.
The economic value of equity ought not be mistaken for the earnings profile of a bank. A general rise in interest rates might support earnings of a bank, however it would typically cause a lessening in the economic value of equity due to the essential inverse relationship between asset values and interest rates and direct relationship (same direction) between values of liabilities and interest rates. However, EVE and bank earnings truly do bear a relationship in that the higher the EVE, the greater the potential for increased future earnings generated from the equity base.
Bank regulators expect banks to conduct periodic EVE calculations.
Limitations of EVE
While the net present value of a bond can be calculated effectively, future cash flows can be challenging to measure for deposit accounts and other financial instruments that have no maturity on the grounds that these types of products have uncertain duration and uneven cash flows. EVE modelers must make suppositions for certain liabilities, which might stray from reality. What's more — on the grounds that EVE is a complete calculation — complex products with embedded options are not effortlessly demonstrated and leave wide room for interpretation and subjective judgment of the modelers or their supervisors.
Features
- Financial regulators expect banks to conduct periodic EVE calculations.
- In contrast to earnings at risk and value at risk (VAR), a bank utilizes the economic value of equity to deal with its assets and liabilities. This is a long-term economic measure used to survey the degree of interest rate risk exposure.
- The economic value of equity (EVE) is a cash flow calculation that takes the current value of all asset cash flows and deducts the current value of all liability cash flows.
