Final answer:
Value at Risk (VaR) focuses on the maximum potential loss with a specific confidence level, while Expected Shortfall (ES) assesses the average loss beyond the VaR threshold, providing insight into tail risk. ES is considered more comprehensive as it captures the magnitude of extreme losses.
Step-by-step explanation:
Value at Risk (VaR) and Expected Shortfall (ES) are both risk measures used in finance to assess the risk of loss on a portfolio. VaR focuses on the maximum loss that can occur with a certain level of confidence over a specific time period. It answers the question: 'What is the worst-case scenario loss we can expect with a given level of confidence?' For instance, if a portfolio has a one-day 5% VaR of $1 million, it means that there is a 95% confidence level that the portfolio will not lose more than $1 million in a day.
On the other hand, ES, also known as Conditional Value at Risk (CVaR), takes into account not just the threshold of loss like VaR, but also the average of the losses that occur beyond that threshold. It provides information on the expected value of loss given that a loss exceeds the VaR. This addresses a key limitation of VaR in that it does not describe the magnitude of extreme losses that can occur beyond the VaR threshold. ES, thus, is considered a measure of the risk in the tail or the extreme losses that a portfolio could face.
To sum up, while VaR is primarily concerned with how much could be lost up to a certain percentile of the loss distribution, ES focuses on the average loss given that the losses have already exceeded the VaR benchmark. This makes ES a more comprehensive risk measure, as it gives a clearer picture of the potential severity of losses in catastrophic scenarios.