Which benefit does VAR-based position limits provide?

Value-at-Risk (VaR)-based position limits are primarily designed to help firms and traders manage their risk exposure effectively. By focusing on the amount of capital that can be allocated to different positions based on their risk, VaR-based limits aim to optimize capital allocation while minimizing potential losses.

When a trading entity uses VaR to set position limits, it assesses the potential loss in value of a portfolio over a specific time frame, given normal market conditions and a certain confidence level. This information allows the firm to allocate its capital more effectively by ensuring that it does not exceed its risk tolerance. In this way, VaR-based position limits serve as a risk management tool, helping to safeguard against dramatic financial losses by ensuring that the capital is deployed in a way that reflects the inherent risks of the positions being taken.

While increased liquidity, enhanced trading opportunities, and the elimination of risk may seem like potential benefits, they do not align as closely with the primary function of VaR-based position limits. Instead, the focus is primarily on reducing risk through informed and effective capital allocation strategies.