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Lost in Diversification

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Document pages: 10 pages

Abstract: As financial instruments grow in complexity more and more information isneglected by risk optimization practices. This brings down a curtain of opacityon the origination of risk, that has been one of the main culprits in the2007-2008 global financial crisis. We discuss how the loss of transparency maybe quantified in bits, using information theoretic concepts. We find that { emi)} financial transformations imply large information losses, { em ii)}portfolios are more information sensitive than individual stocks only iffundamental analysis is sufficiently informative on the co-movement of assets,that { em iii)} securitisation, in the relevant range of parameters, yieldsassets that are less information sensitive than the original stocks and that{ em iv)} when diversification (or securitisation) is at its best (i.e. whenassets are uncorrelated) information losses are maximal. We also address theissue of whether pricing schemes can be introduced to deal with informationlosses. This is relevant for the transmission of incentives to gatherinformation on the risk origination side. Within a simple mean variance scheme,we find that market incentives are not generally sufficient to make informationharvesting sustainable.

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