What does tail risk VAR help to analyze?

Tail risk Value at Risk (VaR) specifically focuses on potential extreme losses that occur beyond the standard range of normal fluctuations in asset prices. It is designed to capture the probability and extent of potential losses that may exceed the more typical risk thresholds. By analyzing these extreme scenarios, tail risk VaR provides insights into the likelihood of extreme adverse outcomes, which are not adequately reflected in conventional risk measures that often focus on average or expected losses.

This approach is particularly important for understanding the risk associated with events that may have a low probability but can result in significant financial repercussions. It allows risk managers and investors to plan for the possibility of catastrophic losses, which are crucial for effective risk management, especially in volatile markets or during periods of financial stress.

Normal fluctuations in asset prices, common risk measures for all assets, and the volatility of average market conditions do not adequately address the extreme scenarios that tail risk VaR is intended to analyze. Ordinary risk assessments may fail to account for these potential outlier events that could materially impact an investment portfolio or financial institution's balance sheet. As such, the focus on losses that exceed typical expectations highlights the critical role of tail risk VaR in comprehensive risk management strategies.