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

A risk manager is comparing VaR and expected shortfall (ES) as the risk measure for economic capital on a portfolio with highly skewed, fat-tailed losses from operational events. Which statement best supports using ES at the same confidence level?

ES is supported because it measures the average loss beyond the VaR threshold, reflecting tail severity, and it is subadditive, so aggregating capital across business units behaves consistently. It is never below VaR at the same confidence and still requires a chosen confidence level.

  1. AES is always smaller than VaR, so it lowers capital requirements
  2. BES captures the size of losses beyond the confidence threshold and is subadditive, aiding aggregation across business unitsCorrect
  3. CES does not depend on the shape of the tail, so it is more stable
  4. DES eliminates the need to choose a confidence level

Explanation

ES averages losses beyond the VaR threshold, so it reflects tail severity, and it is coherent (subadditive), which makes diversification across units consistent. ES is at least as large as VaR, still needs a confidence level, and depends heavily on tail shape.

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