As currently defined, interest rate risk is the risk to earnings or capital
arising from movements in interest rates. Practically, interest rate risk
can be viewed in both a short-term and long-term perspective. To examine
short-term interest rate risk (IRR) we look at Earnings-at-Risk. Conversely,
we use Equity-at-Risk to measure long-term IRR.
Earnings-at-Risk - Short-Term view of IRR
By most definitions, accounting or otherwise, when we communicate something as short-term, we usually refer to a time frame of one year or less. When measuring interest rate risk on an earnings perspective, this same concept applies. Short-term interest rate risk is measured by initially establishing a one year earnings forecast. This base forecast assumes that both the level and structure of market rates of interest are held constant from the last historical period. The balance sheet, in terms of overall size and mix, is constructed using a managerial forecast or a projection.
IRR is a measure of possible loss caused by interest rate changes. Therefore the model introduces two instantaneous, parallel "shocks" to the base set of rates (common practice is to use +/-200bp movements) and then re-computes the expected earnings. The Earnings-at-Risk is the largest negative change between the base forecast and one of the "shock" scenarios. The measure is usually stated as a percentage change of either net interest income or net income.
Equity-at-Risk (EVE) - Long-Term view of IRR
As a means for evaluating long-term interest rate risk, an economic perspective is necessary. This approach focuses on the value of the bank in today’s interest rate environment and that value’s sensitivity to changes in interest rates. This concept is known as Equity-at-Risk. It requires a complete present value balance sheet to be constructed. This is done by scheduling the cash flows of all assets, liabilities, and off-balance sheet items and applying a set of discount rates to in turn develop the present values. The present value of equity is derived by calculating the difference between the present value of assets, liabilities and off-balance sheet items. (Equity = Assets-Liabilities +/- OBS)
Similar to Earnings-at-Risk, two instantaneous, parallel interest rate "shocks" are applied to the base set of rates and all present values are re-computed. Equity-at-Risk is the largest negative change in the present value between the base and one of the "shock" scenarios. This is usually stated as a percentage change or may be presented in dollars as a comparison to a percentage benchmark of the bank’s book assets (1% was suggested by regulators a few years ago).