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EARNINGS-AT-RISK ("EAR")
An attractive methodology for measuring loss percentiles is Earnings-at-Risk, or "EaR." It is based on
historical distributions of earnings. The wider is the dispersion of time series of earnings, the higher is
the risk. Earnings at risk have benefits and drawbacks.

Several measures of earnings can be used: accounting earnings, interest margins, commercial margins,
cash flows, and market values, notably for the trading portfolio. Of course, the larger the data set, the
more relevant the measure will be. The concept applies to any sub-portfolio as well as for the entire
bank portfolio. Once earnings distributions are obtained, it is easy to derive loss percentiles by looking
for some aggregated level of losses that is not likely to be exceeded in more than a given fraction of all
outcomes.

The major benefits of EaR are that they are relatively easy to measure because they are obtained from
accounting data. There are some technical difficulties. For example, the volatility calculation raises
technical issues, for instance when trends make times series, unadjusted for trends, look highly volatile.
In fact, the volatility comes from the trend rather than instability. Hence, relative or percentage
variations of earnings are a better measure of their volatility around the trend. The technique requires
assumptions, but it remains tractable and easy.

EaR provides a number of outputs. The earnings volatility shows the magnitude of variations. The
reduction of earnings volatility, when the perimeter of aggregation increases, measures the
diversification effect. The capital is a loss percentile, or the amount not exceeded by adverse deviations
of earnings in more than a fraction equal to confidence level. It is difficult to conceive a simpler method
of producing a number of outputs without too much effort.

However, the major drawback of EaR relates to risk management. It is not possible to define the sources
of the risk making the earnings volatile. Various types of risks materialize simultaneously and create
adverse deviations of earnings. The contributions of these risks to the final earning distribution remain
unknown. Unlike VaR models, EaR captures risk as an overall outcome of all risks. Without connection to
the sources of risk, market, credit or interest rates, EaR does not allow tracing risks back to where they
come from. EaR is an additional tool for risk management, but not a substitute.

Value at Risk (VaR)

What Is Value at Risk (VaR)?

Value at risk (VaR) is a statistic that measures and quantifies the level of financial risk within a firm,
portfolio or position over a specific time frame. This metric is most commonly used by investment and
commercial banks to determine the extent and occurrence ratio of potential losses in their institutional
portfolios.

Risk managers use VaR to measure and control the level of risk exposure. One can apply VaR calculations
to specific positions or whole portfolios or to measure firm-wide risk exposure.

Value at Risk (VaR)

Understanding Value at Risk (VaR)

VaR modeling determines the potential for loss in the entity being assessed and the probability of
occurrence for the defined loss. One measures VaR by assessing the amount of potential loss, the
probability of occurrence for the amount of loss, and the timeframe.

For example, a financial firm may determine an asset has a 3% one-month VaR of 2%, representing a 3%
chance of the asset declining in value by 2% during the one-month time frame. The conversion of the 3%
chance of occurrence to a daily ratio places the odds of a 2% loss at one day per month.
 Investment banks commonly apply VaR modeling to firm-wide risk due to the potential for independent
trading desks to unintentionally expose the firm to highly correlated assets.

Using a firm-wide VaR assessment allows for the determination of the cumulative risks from aggregated
positions held by different trading desks and departments within the institution. Using the data provided
by VaR modeling, financial institutions can determine whether they have sufficient capital reserves in
place to cover losses or whether higher-than-acceptable risks require them to reduce concentrated
holdings.

Example of Problems with Value at Risk (VaR) Calculations

There is no standard protocol for the statistics used to determine asset, portfolio or firm-wide risk. For
example, statistics pulled arbitrarily from a period of low volatility may understate the potential for risk
events to occur and the magnitude of those events. Risk may be further understated using normal
distribution probabilities, which rarely account for extreme or black-swan events.

The assessment of potential loss represents the lowest amount of risk in a range of outcomes. For
example, a VaR determination of 95% with 20% asset risk represents an expectation of losing at least
20% one of every 20 days on average. In this calculation, a loss of 50% still validates the risk assessment.

The financial crisis of 2008 that exposed these problems as relatively benign VaR calculations
understated the potential occurrence of risk events posed by portfolios of subprime mortgages. Risk
magnitude was also underestimated, which resulted in extreme leverage ratios within subprime
portfolios. As a result, the underestimations of occurrence and risk magnitude left institutions unable to
cover billions of dollars in losses as subprime mortgage values collapsed.

KEY TAKEAWAYS

Value at risk (VaR) is a statistic that measures and quantifies the level of financial risk within a firm,
portfolio or position over a specific time frame.

This metric is most commonly used by investment and commercial banks to determine the extent and
occurrence ratio of potential losses in their institutional portfolios.

Investment banks commonly apply VaR modeling to firm-wide risk due to the potential for independent
trading desks to unintentionally expose the firm to highly correlated assets.
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 present value of all asset
cash flows and subtracts the present value of all liability cash flows. Unlike earnings at risk and value at
risk (VAR), a bank uses the economic value of equity to manage its assets and liabilities. This is a long-
term economic measure used to assess the degree of interest rate risk exposure—as opposed to net-
interest income (NII), which reflects short-term interest rate risk.

The simplest definition of EVE is the net present value (NPV) of a bank's balance sheet's cash flows. This
calculation is used 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.

KEY TAKEAWAYS

The economic value of equity (EVE) is a cash flow calculation that takes the present value of all asset
cash flows and subtracts the present value of all liability cash flows.

Unlike earnings at risk and value at risk (VAR), a bank uses the economic value of equity to manage its
assets and liabilities. This is a long-term economic measure used to assess the degree of interest rate
risk exposure.

Financial regulators require banks to conduct periodic EVE calculations.

Understanding EVE

The 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.
The fair market values of a bank's assets and liabilities are directly linked to interest rates. A bank
constructs models with all constituent assets and liabilities that show the effect of different interest rate
changes on its total capital. This risk analysis is a key tool that allows banks to prepare against constantly
changing interest rates and to perform stress tests.

An internationally accepted standard for determining interest rate risk is to stress-test EVE. The Basel
Committee on Banking Supervision recommends a plus and minus 2% stress test on all interest rates and
US bank regulations require regular analysis of EVE.

The economic value of equity should not be confused with the earnings profile of a bank. A general rise
in interest rates may boost earnings of a bank, but it would normally cause a decrease in the economic
value of equity because of the basic 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 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 require banks to conduct periodic EVE calculations.

Limitations of EVE

While the net present value of a bond can be calculated quite easily, future cash flows can be difficult to
quantify for deposit accounts and other financial instruments that have no maturity because these types
of products have uncertain duration and uneven cash flows. EVE modelers must make assumptions for
certain liabilities, which may deviate from reality. In addition—because EVE is a comprehensive
calculation—complex products with embedded options are not easily modeled and leave wide room for
interpretation and subjective judgement of the modelers or their supervisors.