WHAT IS DIVERSIFICATION?
Diversification of a firm’s risks allows a reduction in the economic capital required. Anything less than a 100% correlation creates a diversification benefit, i.e. a reduction in the capital.
As an example, Risk A has an impact of 3 and Risk B has an impact of 4. At 100% correlation, impact of both together is 7 (simple sum). The fully independent impact of both together is 5, which is the square root of the sum of the squares of each risk. (The square root of the sum of the squares is an acknowledged method for calculating a fully independent impact of any number of risks.) The diversification benefit is therefore between 2 and 0. In practice, you would investigate the diversification benefit of several pairs.
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