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.
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.
Earnings at Risk (EAR)
Earnings at risk (EAR) 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.
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 (VAR)
Value at risk (VAR) 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.
VAR is always calculated with a confidence interval to represent the confidence of loss.
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.
Economic Value of Equity (EVE)
Economic value of equity (EVE) 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.
How Can I Measure Risk?
In finance and investing, there are many ways to measure risk. Some of the most common methods to measure risk include standard deviation, which measures the dispersion of results from the expected value; the Sharpe ratio, which measures the return of an investment in relation to its risk, and beta, which looks at the systematic risk of an investment to the overall market.
What Are the Different Types of Business Risk?
Businesses encounter a lot of risk during their operating life. These risks include financial risks, economic risks, operational risks, reputation risks, fraud risks, and regulatory/compliance risks. There are methods to mitigate all of these risks that businesses should consider implementing.
What Is Risk Tolerance?
Risk tolerance is the measure of how much risk an investor is willing to take on. Theoretically, the higher the risk, the higher the return, but also the higher possibility of loss. Investors with a high risk tolerance are willing to take on more risk, such as investing in riskier products, in the hopes of generating a high return. Investors with a low risk tolerance prefer investing in safer assets, such as Treasuries.
The Bottom Line
Knowing what assets to invest in can be difficult. There is a lot of financial information to go through and a variety of areas to understand. All investors try to pick the assets they believe will appreciate and earn them a profit, but it's not always easy.
There are plenty of financial metrics investors can use to help them on their journey. EAR, VAR, and EVE are three that will provide an investor with different angles on valuation that can help in decision-making.
