Faced with rampant inflation, central banks around the world are raising interest rates. In June, the US Federal Reserve announced its biggest hike since 1994. The previous month, the Bank of England (BOE) had pushed UK rates to a 13-year high. Central banks in Brazil, Canada and Australia have also increased, and the European Central Bank (ECB) is expected to follow suit later this month.
These rate increases not only create turbulence in the risk markets; they can also threaten a company’s financial stability.
The devil is in the details when it comes to quantifying how these hikes will affect a company’s bottom line. Beyond the obvious implications on funding costs, capturing the impact on economic value requires a more strategic and holistic approach.
As we show here, the effect differs depending on how heavy and active the firm’s assets and liabilities are. The calculation becomes even more complex for financial or investment companies that juggle multiple balance sheets at once. However, managing financial risk and hedging market risk is critical to the prosperity of all businesses, so analysts need to understand the tools available to them.
Economic value of capital (EVE)
The economic value of net worth (EVE), or net worth, defines the difference between assets and liabilities according to their respective market values. The EVE represents the income or loss that a company faces during the chosen horizon or period. Therefore, EVE reflects how assets and liabilities would react to changes in interest rates.
EVE is a popular metric used in calculations of interest rate risk in the banking book (IRRBB), and banks usually measure IRRBB against it. But EVE can also help companies, and the analysts who cover them, calculate the risk of their dynamic assets and liabilities.
The metric looks at the calculation of the cash flow that results from offsetting the present value of the expected cash flows of the liabilities, or the market value of the liabilities (MVL), from the present value of all the cash flows of the expected assets, or the market value of the assets. (VAT).
While EVE as a static number is crucial, what also matters to the health of a company is how EVE would perform. exchange for each unit of interest rate movement. Therefore, to calculate the change in EVE, we take the delta (d) of the market values for both the asset and the liability. This is, dEVE = dMVA – dMVL.
The beauty of this measure is that it quantifies the ΔEVE for any chosen time cube and allows us to create as many different cubes as we need. The table below tracks the changes in a hypothetical company’s EVE assuming a parallel 1 basis point increase in interest rates.
| bucket | dMVA | dMVL | dVIGIL |
| 1 month | -$13,889 | $35,195 | $21,306 |
| 2 months | -$27,376 | $9,757 | -$17,620 |
| 3 months | -$39,017 | $16,811 | -$22,205 |
| 6 months | -$180,995 | $72,449 | -$108,546 |
| 1 year | -$551,149 | $750,815 | $199,667 |
| 3 years | -$3,119,273 | $1,428,251 | -$1,691,023 |
| 5 years | -$1,529,402 | $115,490 | -$1,413,912 |
| More than 5 years | -$264 | $403 | $139 |
| Net change | -$5,461,364 | $2,429,170 | -$3,032,194 |
What is an acceptable EVE?
Economic intuition tells us that long-term assets and liabilities are more vulnerable to changes in interest rates because of their rigidity, so they are not subject to short-term readjustments. In the chart above, the net change in EVE is -$3,032,194 for each basis point increase across the interest rate curve, and we have the granularity needed to determine the segments where the company is most vulnerable
How can a company bridge this gap? What is the optimal distribution between the duration/amounts of assets and liabilities? First, each institution has its own optimal allocation. One size does not fit all. Each company’s risk profile and pre-set risk appetite will drive the optimal EVE. Asset Liability Management (ALM) is definitely an art – it helps realize the risk profile of the company.
Because EVE is primarily a long-term metric, it can be volatile when interest rates change. This requires applying market best practices when following a stress technique such as Value at Risk (VaR), which helps to understand and anticipate future movements in interest rates.
On and off the balance sheet
A company can manage the EVE gap between assets and liabilities, and related risk mitigation practices, either on or off the balance sheet. An example of balance sheet hedging is when a company simply obtains financing at a fixed interest rate, rather than linking it to a floating index, such as US LIBOR, or issuing a fixed bond to normalize the duration gap between assets and liabilities
Off-balance sheet hedging maintains the mismatch in assets and liabilities, but uses financial derivatives to synthetically create the desired outcome. In this approach, many companies use vanilla interest rate swaps (IRS) or interest rate derivatives.
Details of the balance sheet gap are not always available for examination when reviewing financial statements. However, decision makers and investors should pay attention and be aware that the EVE metric captures the market value of accumulated cash flows over the next few years. And as we have shown above, calculating it is simple.
A safety valve for an uncertain future
With a little due diligence, we can better understand how a company manages its interest rate exposure and the associated ALM processes. While banks and large financial institutions make extensive use of the EVE indicator, other companies should as well. And so should analysts.
When a company sets risk limits, monitors them, and understands the accompanying changes in value due to movements in interest rates and how they will affect its financial position, it creates a safety valve that protects against market risks and insight uncertainty of interest rates.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images/Heiko Küverling
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Muadh Alhusaini, CFA, FRM, CAIA
