Conditional Value at Risk (CVaR) is a risk management tool used to gauge possible financial losses, and can be used as a measure of risk exposure when determining how portfolios and investments are structured. It is similar to Value at Risk (VaR) in that it estimates the potential magnitude of future losses associated with a particular portfolio or investment. CVaR, however, provides a much more conservative approach than VaR and has become popular for its ability to identify risks to which a portfolio may be exposed.

CVaR steps in to fill the gap when VaR falls short. VaR assumes that portfolio losses will be normally distributed and can calculate losses upon a set threshold. This means that VaR does not account for extreme outliers, or ‘tail risks’, which can have a significant impact on portfolio growth. CVaR looks further along the probability distribution, calculating risk factors within the tails of the graph. It does this by looking at quantiles defined as ‘expected shortfall’, also known as tail VaR, and can measure more extreme tail risks.

As CVaR takes into account events that fall outside the scope of VaR, it can be used when dealing with portfolio’s with inherently volatile or engineered investments. Its ability to measure tail risks can assist managers in making decisions around portfolio diversification and other risk management practices.

At the same time though, it is important to be aware that CVaR isn’t free from limitations. While it can identify more extreme tail events, it doesn’t provide the kind of forward-looking estimates that VaR does and can’t directly inform strategic decisions. When used effectively though, CVaR can provide a valuable level of scrutiny to ensure the assumptions used when calculating VaR are valid.

In conclusion, knowing when to use VaR or CVaR requires careful assessment of risks and expected returns. CVaR encompasses a more expansive view of risks which can be especially useful when dealing with volatile assets. Ultimately, a combination between the two metrics can be used to build a comprehensive picture of risk exposure and enable managers to make informed decisions with regards to portfolio diversification and other risk management practices.