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Diversification, hedging, and “pacification”

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  • Michael R. Powers

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).

Suggested Citation

  • Michael R. Powers, 2010. "Diversification, hedging, and “pacification”," Journal of Risk Finance, Emerald Group Publishing Limited, vol. 11(5), pages 441-445, November.
    • Handle: RePEc:eme:jrfpps:15265941011092031
    DOI: 10.1108/15265941011092031
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