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L.3 · INTERMEDIATE · 2 MIN

Beyond VaR: Expected Shortfall and Tail Risk

VaR tells you the threshold but says nothing about how bad it gets beyond that threshold. Expected Shortfall (Conditional VaR) answers: given that we’re in the worst 5%, what’s the average loss?

Quiz · 5 questions ↓

Compare

MetricQuestion AnsweredLimitation
VaR (95%)What’s the worst loss 95% of the time?Says nothing about the other 5%
Expected Shortfall (95%)When losses exceed VaR, what’s the average?Harder to backtest
Maximum DrawdownWhat’s the worst peak-to-trough decline?Only uses one data point (the worst)

Key point

Expected Shortfall is always larger than VaR and gives a more honest picture of tail risk. If your 95% VaR is $50K but your Expected Shortfall is $150K, the tail is very fat — your rare bad days are three times worse than the VaR threshold suggests.

Try it

Compare VaR to Expected Shortfall for your portfolio. If ES is much larger than VaR, your portfolio has significant tail risk — the rare bad events are much worse than the typical bad event.

Check-in

Portfolio A: VaR $50K, ES $60K. Portfolio B: VaR $50K, ES $200K. Same VaR, very different risk profiles. Which is riskier?

Key insight

Tail risk is where portfolios blow up. VaR models failed in 2008 because they underestimated the severity of tail events. Always supplement VaR with Expected Shortfall and stress testing.

Check-in

Portfolio A: 95% VaR $100K, 99% VaR $200K, Expected Shortfall (95%) $250K. Portfolio B: 95% VaR $100K, 99% VaR $150K, ES $140K. Which has worse tail risk?
Check your understanding

Sit with the ideas.

Two portfolios both report a 95% daily VaR of $50,000. Portfolio X holds diversified large-cap stocks. Portfolio Y holds concentrated biotech positions. Which likely has higher Expected Shortfall, and why?

Why:
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Other lessons in this course.

  1. 01Value at Risk: Three Ways to Measure Worst-Case Losses
  2. 02Adverse Selection and Market Unraveling
  3. 03Beyond VaR: Expected Shortfall and Tail Risk— reading now
  4. 04Portfolio Risk Decomposition: Where Is Your Risk Coming From?
  5. 05Stress Testing and Scenario Analysis
  6. 06Hedging Strategy Selection: When, What, and How to Hedge
  7. 07Risk-Adjusted Returns: Measuring What Matters
  8. 08Behavioral Risk Biases: The Investor's Worst Enemy
  9. 09Jensen's Inequality and Precautionary Saving
  10. 10Stochastic Dominance and Ranking Risky Payoffs
  11. 11The Two-Period Consumption-Savings Model
  12. 12Adverse Selection: Pooling and Separating Equilibria
  13. 13Moral Hazard and Agency Costs
  14. 14Knightian Uncertainty and Ambiguity Aversion
  15. 15Risk Metrics: Sharpe, Beta, and Drawdown
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