Asset-Liability and Liquidity Management

CHAPTER 8Economic Value of Equity

The ultimate goal of a balance sheet management team is to increase shareholders' return on equity (ROE). Since values of a firm's assets and liabilities fluctuate by changes in market conditions, the value of the firm's equity also changes accordingly. The structure of assets and liabilities with respect to type, term, and mixture directly affects the real value of firm's equity, and hence it is crucial for equity holders to monitor and evaluate the firm's approach in asset-liability management. In particular, it is important for shareholders to have a measurement of a potential change in equity value if market conditions, such as interest rates or cross-currency exchange rates, change.

In this chapter we introduce the concept of economic value of equity (EVE) and explain various methods to study the impact of changes in market conditions on the EVE of a financial company. Derivation of the EVE involves the use of various valuation techniques and many assumptions, many of them introduced in earlier chapters. To reduce the effect of assumptions and calculation methods, firms usually focus on change in economic value of equity (ΔEVE) for different scenarios while keeping the underlying assumptions and calculation methods the same in all scenarios. This way they can concentrate on the impact of changes in market conditions on equity.

For an EVE analysis we need to make decisions on two important topics beforehand. First, we need to decide how ...