Financial Risk Manager Part 2
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A financial institution has predominantly relied on Value at Risk (VaR) as its primary risk assessment tool. Given the recent market volatility, the institution is considering the adoption of Expected Shortfall (ES) as a potentially more effective alternative. Before transitioning from VaR to ES, what are the essential differences and key insights that need to be understood about both Value at Risk and Expected Shortfall?
A financial institution has predominantly relied on Value at Risk (VaR) as its primary risk assessment tool. Given the recent market volatility, the institution is considering the adoption of Expected Shortfall (ES) as a potentially more effective alternative. Before transitioning from VaR to ES, what are the essential differences and key insights that need to be understood about both Value at Risk and Expected Shortfall?
Explanation:
The correct answer is A. Expected shortfall (ES) is always greater than or equal to Value at Risk (VaR) for a given confidence level, because VaR measures the minimum loss that will not be exceeded with a certain probability (α), while ES accounts for the severity of expected losses beyond VaR. This means that ES not only captures the likelihood of losses but also the magnitude of potential losses in the tail of the distribution, making it a more comprehensive risk measure, especially during market turmoil. The other options are incorrect: B is false as a VaR backtest acceptance does not ensure the accuracy of ES; C is incorrect because VaR is not subadditive, whereas ES is; and D is false since backtesting ES is more complex due to the need to consider both the frequency and the magnitude of VaR violations.