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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank's economic capital model uses 99.9% VaR. A risk manager proposes switching to expected shortfall (ES) at 99% to calibrate capital. Which statement about this proposal is most accurate?

Expected shortfall is coherent, including subadditivity, and measures the average loss beyond the VaR threshold, so it captures tail severity that VaR ignores. It is never below VaR at the same confidence level, which makes it a reasonable alternative for economic capital.

  1. AES is a coherent risk measure that reflects the severity of losses beyond the threshold, while VaR ignores the size of losses beyond the quantileCorrect
  2. BES is not subadditive, so it cannot be used for capital attribution across business units
  3. CES at 99% is always lower than VaR at 99%
  4. DES ignores losses in the tail beyond the quantile

Explanation

ES is the average loss conditional on exceeding VaR, so it captures tail severity and is subadditive (coherent). VaR is not subadditive in general. ES at a given level is always at least VaR at the same level, so the third option is wrong.

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