Explain how risk measures can guide decisions on allocating capital

Economic capital, the amount needed to absorb large unexpected losses, is often set from VaR, stress losses or both. Each activity's profit is then judged relative to the capital it uses: a desk earning 12 million on 60 million of allocated capital returns 20%, more than one earning 15 million on 100 million. Capital can be allocated by notional size, by VaR, by stress loss or through a formal risk budget, and ideally reflects diversification between activities. The aim is to direct capital where risk-adjusted return is highest and exceeds a hurdle rate. The trap is ranking activities by profit alone, rather than by profit per unit of risk capital.