I use these two terms almost on a daily basis. Indeed I’ve talked about earnings and equity simulations numerous times on this site; the latest covering a very specific relationship between the two.
I think what I often overlook, or take for granted, is that everyone understands the mechanics of earnings and equity simulations. However, the frequent questions and comments I get from clients and examiners suggest that many don’t get it. The questions are often awkward or confusing, and some are even nonsensical. I will address some of these questions in future posts as part of this series. But before I do, I want to outline some basics.
The core concept in both types of simulations is basically the same. We start by establishing a base-case measurement. Then we look at other alternative stress-tests and compare their measurements back to the base. A typical stress-test might be a +/-200bp shock to market rates - this would provide us with two alternative measurements to compare back to the base-case measurement.
Where earnings and equity simulations differ from one another is that they each use a different base-case measurement:
- Earnings simulation –> typically looks at net interest income or margin
- Equity simulation –> typically looks at economic value of equity (EVE)
This may seem like a basic and obvious distinction, but there’s a key characteristic difference between the two measurements. That difference is time-frame. When we want to measure earnings we use an income statement. When we want to measure equity we use a balance sheet. Remember that an income statement represents a period of time. This contrasts with a balance sheet, which represents a single moment in time.
The earnings simulation will capture cash flows over a period of time into the future. These future cash flows may be generated by existing business (e.g. current loans or current deposits) or they may be generated by future business (e.g. new loans or new deposits booked at some point in the future.) By contrast when we evaluate the present value or economic value on the balance sheet we are considering only the future cash flows generated by existing business. New loans or deposits that might be generated in the future do not impact the present day equity simulation. Changes in market rates that happen in the future do not impact the present day equity simulation.
Understanding this fundamental difference is key to understanding what possible stress-tests you can (and cannot) run. It’s also key to understanding why these two interest rate risk measurements may indicate seemingly different exposures.
(This post is part of a series which provides a basic overview and discussion of interest rate risk stress-testing.)