Question

What is Expected Shortfall? Explain its similarities and differences from "Value at Risk". Using an example, show how Expected Shortfall and Value at Risk concepts help financial institutions manage interest rate risk? What are their respective problems, uses and advantages? Why is Basel Committee ( in III ) recommending Expected Shortfall while earlier it had recommended Value at Risk for measuring risk capital? Is expected shortfall a more optimal measure for analyzing the impact on bank's capital? Why or Why not? How do we address the shortcomings of expected shortfall?

Answer 1

Expected shortfall means the average losses which are greater than or equal to the value at risk. The average loss in the expected shortfall is worst (1-p)%. Where "P" is the confidential level. If the value of the P is lesser than 1 then it is the worst scenario thing. it gives the value of the q%. It is always important to clarify that CVaR should not be the worst case scenario. As the worst case scenario is the 100% loss of the initial investment made by the investors. CVaR can be simply classified as the average losses of the past arbitrarily selected risk threshold. VaR will be 95% and CVaR will be 5% representing the average outcomes in the worst cases. In simple term it can be said as the Expected Shortfall is the opposite of Expected Upside.

Expected Shortfall help the investors to know that they are going to get the returns or not. As the shortfall formula helps them to know to make the investment in the X organization or not. Basel committee recommends to use the Expected shortfall formula instead of using Value at risk formula to measure the risk the capital. As Expected Shortfall Formula can give the clear data about the risks and returns for the investment of the organization. on the other hand the value at risk formula cannot give the real vision of the return of the returns on the investment. This can only show the risk appetite to the investors.

Yes Expected Shortfall is the optimal measure for analyzing the impacts of the bank's capital as it gives the clear vision of the profit or loss on the value of investment made. As I mentioned in the First paragraph if the value of the P is greater than 1 then its the positive sign for the investors to make the investment but if the value of the P is lesser than the value of 1 then its not good for the investors to make an investment as the amount of investment is going to give them only losses.