Diversification, hedging, and “pacification”

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).

Citation

Powers, M.R. (2010), "Diversification, hedging, and “pacification”", Journal of Risk Finance, Vol. 11 No. 5, pp. 441-445. https://doi.org/10.1108/15265941011092031