What method is used for allocating capital based on estimated exposure?

The method that focuses on allocating capital based on estimated exposure is the use of Value at Risk (VaR) based position limits. This approach involves estimating the potential losses in value of an investment or portfolio over a defined period for a given confidence interval. By determining the VaR, firms can assess the risk exposure of their investment positions and allocate capital accordingly to ensure that the potential losses do not exceed acceptable limits.

In contrast, a fixed percentage of total capital lacks the nuance of actual risk assessment and can lead to overexposure in high-risk environments or underutilization in low-risk scenarios. Equal distribution among assets disregards the different risk and return profiles of investments, leading to inefficient capital allocation. Historical average returns focus solely on past performance rather than current risk exposure metrics, which can misguide capital allocation in a volatile market.

The VaR method allows for a more proactive and informed approach to managing risk, thereby promoting better capital allocation that considers the unique risk characteristics of each investment.