Diversification, hedging, and “pacification”

Michael R. Powers

Journal of Risk Finance, 2010, vol. 11, issue 5, 441-445

Abstract: Purpose - The purpose of this paper is to explore the roles of diversification, hedging, and a third risk‐reduction process – “pacification” – in risk finance. Design/methodology/approach - After briefly reviewing the concepts of diversification and hedging, a simple mathematical model is offered for reducing the standard deviation of a portfolio of traditional “insurance” and/or other financial risks. Findings - The findings show that: neither diversification nor hedging, by itself, can guarantee a reduction of a portfolio's standard deviation; diversification and hedging, taken together, are still insufficient to guarantee a reduction of a portfolio's standard deviation; but either diversification or hedging, taken together with pacification, is sufficient to guarantee a reduction of a portfolio's standard deviation. Originality/value - The paper provides a simple mathematical model for diversification and hedging, and also quantifies a further risk‐reduction process (pacification).

Keywords: Portfolio investment; Diversification; Hedging; Standard deviation; Risk management (search for similar items in EconPapers)
Date: 2010
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Persistent link: https://EconPapers.repec.org/RePEc:eme:jrfpps:15265941011092031

DOI: 10.1108/15265941011092031

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