Risk managing tail-risk seekers: VaR and expected shortfall vs S-shaped utility

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We consider market players with tail-risk-seeking behaviour modelled by S-shaped utility, as introduced by Kahneman and Tversky. We argue that risk measures such as value at risk (VaR) and expected shortfall (ES) are ineffective in constraining such players, as such measures cannot reduce the traders expected S-shaped utilities. Indeed, when designing payoffs aiming to maximize utility under a VaR or ES risk limit, the players will attain the same supremum of expected utility with or without VaR or ES limits. By contrast, we show that risk management constraints based on a second more conventional concave utility function can reduce the maximum S-shaped utility that can be achieved by the investor. Indeed, product designs leading to progressively larger S-shaped utilities will lead to progressively lower expected constraining conventional utilities, violating the related risk limit. These results hold in a variety of market models, including the Black Scholes options model, and are particularly relevant for risk managers given the historical role of VaR and the endorsement of ES by the Basel committee in 2012--2013.
Original languageEnglish
Pages (from-to)122-135
Number of pages14
JournalJournal of Banking and Finance
Early online date29 Jan 2019
Publication statusPublished - 1 Apr 2019


  • Concave utility constraints
  • Concave utility risk constraints
  • Effective risk constraints
  • Expected shortfall constraints
  • Limited liability investors
  • Optimal product design under risk constraints
  • S-Shaped utility maximization
  • Tail-risk-seeking investors
  • Value at risk constraints


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