Diversification
Risks can be reduced in four main ways: Avoidance, Diversification, Hedging and Insurance by transferring risk. Systemic risk, also called market risk or un-diversifiable risk, is a risk of security that cannot be reduced through diversification. Participants in the market, like hedge funds, can be the source of an increase in systemic risk and transfer of risk to them may, paradoxically, increase the exposure to systemic risk.
Until recently, many theoretical models of finance pointed towards the stabilizing effects of diversified (i.e., dense) financial system. Nevertheless, some recent work has started to challenge this view, investigating conditions under which diversification may have ambiguous effects on systemic risk. Within a certain range, financial interconnections serve as shock-absorber (i.e., connectivity engenders robustness and risk-sharing prevails). But beyond the tipping point, interconnections might serve as shock-amplifier (i.e., connectivity engenders fragility and risk-spreading prevails).
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