On the first page of Chapter 20, the notes say: "Diversification effects arise because the various risks from a company's operations are not independent. Since risks are not independent, the sum of the standalone capital requirements for each risk will usually be greater than the capital requirement for all risks combined." This seems to me to be the opposite of the truth. Rather, it is the fact that risks are not completely correlated that means that the combined capital requirements for all risks are less than the sum of the standalone capital requirements. For instance, if we have a set of risks that are 100% correlated then the sum of the standalone requirements will be equal to the combined requirement, whereas if the risks are only "50% correlated", say, then we will have a diversification benefit which will act so as to reduce th combined capital requirement below the sum of the stadalone capital requirements. I would re-phrase the notes to something like: "Diversification effects arise because the various risks from a company's operations are at least partially independent. Since risks are not perfectly correlated, the sum of the standalone capital requirements for each risk will usually be greater than the capital requirement for all risks combined." Is there something I'm missing here? I'm not taking ST7 - rather I'm taking SA3 and I'm using ST7 for background, so I'm probably not as familiar with the material here as I would be if I were taking the exam.
Yes, I think you're right, thanks for the suggested improvement. We'll ask for the Core Reading to be changed. I think there's too many double negatives, and confusing diversification with correlation that makes the whole thing a bit messy to read!
