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On the Measurement of Economic Tail Risk

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  • Steven Kou

    (Risk Management Institute and Department of Mathematics, National University of Singapore, Singapore 119077)

  • Xianhua Peng

    (Department of Mathematics, The Hong Kong University of Science and Technology, Hong Kong)

Abstract

This paper attempts to provide a decision-theoretic foundation for the measurement of economic tail risk, which is not only closely related to utility theory but also relevant to statistical model uncertainty. The main result is that the only risk measures that satisfy a set of economic axioms for the Choquet expected utility and the statistical property of general elicitability (i.e., there exists an objective function such that minimizing the expected objective function yields the risk measure) are the mean functional and value-at-risk (VaR), in particular the median shortfall, which is the median of tail loss distribution and is also the VaR at a higher confidence level. We also discuss various approaches of backtesting and their relations to elicitability and co-elicitability; in particular, we show that the co-elicitability of VaR and expected shortfall does not lead to a reliable backtesting method for expected shortfall and there have been only indirect backtesting methods for expected shortfall. Furthermore, we extend the result to address model uncertainty by incorporating multiple scenarios. As an application, we argue that median shortfall is a better alternative than expected shortfall for setting capital requirements in Basel Accords.

Suggested Citation

  • Steven Kou & Xianhua Peng, 2016. "On the Measurement of Economic Tail Risk," Operations Research, INFORMS, vol. 64(5), pages 1056-1072, October.
  • Handle: RePEc:inm:oropre:v:64:y:2016:i:5:p:1056-1072
    DOI: 10.1287/opre.2016.1539
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    7. Cornilly, D. & Rüschendorf, L. & Vanduffel, S., 2018. "Upper bounds for strictly concave distortion risk measures on moment spaces," Insurance: Mathematics and Economics, Elsevier, vol. 82(C), pages 141-151.
    8. Laurent Gardes & Stéphane Girard & Gilles Stupfler, 2020. "Beyond tail median and conditional tail expectation: Extreme risk estimation using tail Lp‐optimization," Scandinavian Journal of Statistics, Danish Society for Theoretical Statistics;Finnish Statistical Society;Norwegian Statistical Association;Swedish Statistical Association, vol. 47(3), pages 922-949, September.
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    15. Ruodu Wang & Johanna F. Ziegel, 2021. "Scenario-based risk evaluation," Finance and Stochastics, Springer, vol. 25(4), pages 725-756, October.
    16. Wu, Qi & Yan, Xing, 2019. "Capturing deep tail risk via sequential learning of quantile dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 109(C).
    17. Xue Dong He & Xianhua Peng, 2017. "Surplus-Invariant, Law-Invariant, and Conic Acceptance Sets Must be the Sets Induced by Value-at-Risk," Papers 1707.05596, arXiv.org, revised Jan 2018.
    18. Marcelo Brutti Righi, 2018. "A theory for combinations of risk measures," Papers 1807.01977, arXiv.org, revised Aug 2020.
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