Expected Shortfall: Meaning, Formula, Example And Importance

Key takeaways 
 

• Investors use expected shortfall for measuring how much loss they can face in extreme adverse situations.
   
• There are other tools which tell about future uncertainties but expected shortfall gives an idea about the worst possible case. Software like MATLAB and R helps in calculating expected shortfall. 
   
• The market is never steady, there are always uncertainties. To control financial risk investors, managers and banks use expected shortfall methods. 

Risk management is one of the most important concepts in the finance world. It saves investors and organisations from extreme loss. In risk management, expected shortfall is a crucial term. It is often referred to as ES. This is a tool used during estimation of profit and loss. It gives an idea of average loss that an investor can face in future. Expected shortfall is also known as conditional Value at Risks (VaR). Because it calculates the average loss that can occur beyond the normal value risk. 

Suppose, there is an investor investment in ₹1,00,000 shares. Now, the investor knows that he won't face a loss of more than ₹5,000, in 95% of situations. But he doesn't know about 5%. In the worst case of 5%, the expected shortfall gives you a loss. This means If market performance is very bad, then what loss investors can suffer. 

How to Calculate Expected Shortfall

Here is a step by step explanation to calculate the expected shortfall.

The first step is to calculate the value at risk(VaR). VaR gives you confidence level, meaning the point at which you will not face any loss. Like, if your investment is 100 and confidence level is 90% , your 90 is safe. 

Here is formula to calculate VaR

Value at Risk = Vm Vi/Vi-1 

Vi = number variable 

Vm = number of days 

The second step is to identify the values that are more than VaR. After that calculate expected shortfall by averaging exceeding loss. Like, if VaR is 90 and losses recorded 86, 88, 92, 94, and 96. Here loss that exceeds is 92, 94, and 96. 

92+94+96/3 = 94

The expected shortfall is 94.

Bonus tip - Do you know? In recent regulatory frameworks, Expected Shortfall (ES/CVaR) is preferred over Value at Risk, because ES captures average losses in the worst-case tail and satisfies the properties of a coherent risk measure, which VaR does not.

Difference Between VaR and Expected Shortfall

Value at risk shows loss that is highly expected but it focuses on threshold. The calculation is easy for VaR. Expected shortfall shows average loss. And this shows the gravity of loss that is beyond threshold. The expected shortfall gives more details, not only the threshold. Investors and companies use expected shortfall for accurate results. 

Advantages and limitations of expected shortfall 

Expected shortfall is a method used by investors to predict loss. It has both advantages and disadvantages mentioned below.

The expected shortfall is very accurate and powerful but needs detailed information about data. 

Conclusion 

The expected shortfall is a very advanced tool. Financial institutions and investors prefer this over any other risk management tool because it's highly accurate. Managers use Expected shortfall to manage their portfolios. Value at risk (VaR) is used to see possible loss. It is important to calculate expected shortfall. 

FAQs 

What is the expected shortfall in simple terms?

Expected shortfall gives average loss to the investors and helps them manage their portfolios. First, value at risk is calculated and then average shortfall. 

What is the difference between VaR and expected shortfall?

Value at risk (VaR) is a tool, it gives loss which has maximum possibility. Expected shortfall is calculated to find average loss. These losses are beyond VaR.