Diversification, hedging, and “pacification”

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).