ACTSC 445/845: Quantitative Risk Management

Fall 2022

Erik Hintz
Department of Statistics and Actuarial Science
erik.hintz@uwaterloo.ca

Lecture 05

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 Today’s Agenda

Last time:

Two very important risk measures:

I Value-at-risk
I Expected shortfall (only the definition)

Today (Lec 5, 09/22):

More on ES

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 Review

What is the mathematical definition of the generalized inverse of an

increasing function T ?
What is the definition and interpretation of the VaRα (L) where L is a loss
random variable?
What advantages/disadvantages does the risk measure VaRα have?

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Chapter 2: Basic Concepts in Risk Management

2.3. Risk Measurement

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 Expected Shortfall

We use the notation x+ = max{x, 0} = x · 1x ≥0

Definition
For a loss L ∼ FL with E(L+ ) < ∞ the expected shortfall at confidence level
α ∈ (0, 1) is defined as
Z 1
1
ESα = ESα (L) = VaRu (L)du
1−α α

ESα is the average of VaRu over all u ≥ α

⇒ ESα ≥ VaRα
Besides VaR most important risk measure in practice
Advantages and drawbacks will be discussed later.

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 Value-at-risk and Expected Shortfall

0.8
0.6
Density

0.4
0.2

2.5% mass
0.0

0 E(L) VaR0.975 ES0.975 4

Figure: VaR0.975 and ES0.975 for L ∼ Gamma(2, 2)

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 Expected Shortfall

There are also different formulas for ESα depending on properties of FL :

Proposition
If FL is continuous
ESα (L) = E(L | L > VaRα (L))

Thus, if FL is continuous, ESα is the conditional tail expectation, sometimes

also called conditional VaR.
Remark
If FL is discontinuous, this proposition cannot be applied. In this case,

E(L1{L>VaRα (L)} ) + VaRα (L) · (1 − α − F L (FL← (α)))

ESα (L) =
1−α

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Proof.

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 ES for the normal and t-distribution

Example (ES for the normal and t-distribution)

Let α ∈ (0, 1).
Let L ∼ N (µ, σ2 ). Then

φ Φ −1 ( α )


ESα (L) = µ + σ
1−α

Let L ∼ tν (µ, σ2 ) for some ν > 1. Then

2 !
ft t − 1 ( α ) ν + tν−1 (α)


ESα (L) = µ + σ ν ν
1−α ν−1

where tν (·) is the cdf of tν (0, 1) and ftν (·) is the density of tν (0, 1)

Proof.
Whiteboard for the normal case, the t case should be done as an exercise
(similar to the normal case).

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 Comparing ES and VaR
It is often useful to look at the limiting shortfall-to-quantile ratio given by
ESα (L)
lim ≥1
α →1 VaRα (L)

Let L ∼ N(µ, σ2 ). Then (exercise)

ESα (L) φ(x )/x l’H

lim = · · · = lim = ··· = 1
α →1 VaRα (L) x → ∞ 1 − Φ (x )

where l’H stands for ”l’Hospital’s rule”. In this case, from a RM

perspective, in the limit for large α it does not matter if VaRα or ESα is
used.
Let L ∼ tν (µ, σ2 ). Then (exercise)

ESα (L) ν
lim =
α →1 VaRα (L) ν−1

Note: For instance with ν = 3 (not unreasonable!), in the limit for large α,
ES is approximately 50% larger than VaR. Hence, for heavy tailed
distributions, the difference between ES and VaR is more pronounced, for
large α. Think of what would happen for ν → 1.
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Example (A comparison between VaR and ES for stock returns)
Consider the stock portfolio example with d = 1 (one stock portfolio) and
assume St = Vt = 10, 000. Then we have

Lt∆+1 = −St Xt +1 , Xt +1 = log(St +1 /St )

√
Consider two different models for Xt +1 , normal and t. Let σ = 0.2/ 250, i.e.
annualized volatility of 20%. Assume one of the following:
Xt +1 ∼ N(0, σ2 ). Then

Lt∆+1 ∼ N(0, St2 σ2 )

so that Var(Lt∆+1 ) = St2 σ2 .

Xt +1 ∼ tν 0, σ2 ν− 2
for ν > 2. In this case Var(Xt +1 ) = σ2 (same as


ν
above). Then
2 2ν−2
 
∆
Lt +1 ∼ tν 0, St σ
ν
so that Var(Lt∆+1 ) = St2 σ2 , as above for fair comparability.

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 ESα for t3.75 model
VaRα for t3.75 model
ESα for normal model
VaRα for normal model
500
0
−500

0.001 0.005 0.010 0.050 0.100 0.500 1.000

1−α

Only for sufficiently large α it holds that VaRtα3.75 ≥ VaRNormal

α and
EStα3.75 ≥ ESNormal
α
⇒ t3.75 model not always ”riskier” than the normal model!

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 Law of Large Numbers for ES

Lemma
Let L1 , L2 , . . . be a sequence of iid random variables with cdf FL . For n ∈ N,
denote by L(1),n ≤ L(2),n ≤ · · · ≤ L(n),n the order statistics (sorted values,
increasing) of L1 , . . . , Ln . Then, almost surely,
n
∑ L(i ),n
i =dαne+1
lim = ESα
n→∞ n − dαn e

Proof.
See eg Acerbi and Tasche (2002): ”On the coherence of expected shortfall”.
https://doi.org/10.1016/S0378-4266(02)00283-2, Prop. 4.1.
ES can be thought of as the limitting average of the n − dαn e largest
order statistics of a sample of size n. Thus, given a large sample of size n,
one can estimate ESα by averaging the n − dαn e largest sample points.
(e.g. n = 100, α = 0.975 ⇒ average the 100-98=2 largest sample points)

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 Exercise: Estimating VaRα and ESα

Consider the following n = 10 iid realizations of some loss rv L (sorted

increasingly):
−5, −4, 2, 5, 6, 9, 10, 11, 14, 15
Estimate the following risk measures:
VaRα (L) for α ∈ {0.8, 0.9, 0.95, 0.99}
ESα (L) for α ∈ {0.8, 0.9, 0.95, 0.99}

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 Discussion of ESα
Advantages
Makes sense on all levels/across
portfolios
Interpretable
What-if measure, i.e. severity
based: Looks further into the tail
Subadditive, and thus coherent
(later)
Drawbacks
ESα (L) < ∞ requires E(L+ ) < ∞
Typically more difficult to
estimate than VaRα (larger
sample sizes required)
Not elicitable
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