Exploitation Fund managed by the Welsh Assembly Government.

Risk Measurement and Management in a Crisis-Prone World The current \u85nancial crisis has highlighted once again the importance of risk management in the modern world of \u85nance, where institutions such as banks and major hedge funds are said to fail inevitably from time to time. The collapse of Barings in 1995, the LTCM crisis three years later, and recently the debacles of Northern Rock, Bear Stearns and Lehman Brothers are testimonies to the above statement. The two factors that underlie the \u85nancial crises in the past two decades are leverage and portfolio of complex \u85nancial derivatives. This motivates us to look again into the sources of risk at the tail of the distribution. In particular, we investigate the risk contribution of an asset, which has infrequent but huge losses when leverage is high, to a portfolio using two risk measures, namely Value-at-Risk (VaR) and Expected Shortfall (ES). While ES is found to measure the tail risk contribution e¤ectively, VaR is consistent with intuition only if the underlying return distribution is well behaved. Having shown that ES is a preferred risk measure to quantify tail risk, ES backtesting is the next objective of the paper. This is because (i) backtesting enables ris