The purpose of this paper is to explore the roles of diversification, hedging, and a third risk‐reduction process – “pacification” – in risk finance.
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.
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.
The paper provides a simple mathematical model for diversification and hedging, and also quantifies a further risk‐reduction process (pacification).
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