A LARGE COMMERCIAL BANK IS USING VAR AS ITS MAIN RISK MEASUREMENT...

17.

A large commercial bank is using VaR as its main risk measurement tool. Expected shortfall (ES) is suggested

as a better alternative to use during market turmoil. What should be understood regarding VaR and ES before

modifying current practices?

a.

Despite being more complicated to calculate, ES is easier to backtest than VaR.

b.

Relative to VaR, ES leads to more required economic capital for the same confidence level.

c.

While VaR ensures that the estimate of portfolio risk is less than or equal to the sum of the risks of that

portfolio’s positions, ES does not.

d.

Both VaR and ES account for the severity of losses beyond the confidence threshold.

Correct Answer: b

Rationale:

Expected shortfall is always greater than or equal to VaR for a given confidence level, since ES accounts

for the severity of expected losses beyond a particular confidence level, while VaR measures the minimum expected

loss at that confidence level. Therefore, ES would lead to a higher level of required economic capital than VaR for

the same confidence level. In practice, however, regulators often correct for the difference between ES and VaR by

lowering the required confidence level for banks using ES compared to those using VaR.

Section: Market Risk Measurement and Management

Reference:

Basel Committee on Banking Supervision, Messages from the Academic Literature on Risk Measurement

for the Trading Book, Working Paper No. 19, January 2011.

Learning Objective:

Compare VaR, expected shortfall, and other relevant risk measures.

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2015 Financial Risk Manager (FRM®) Practice Exam