Jorund Holterud Aarsnes & Stephan Jensen

Title: ‘Diversification, Interconnectedness and Systemic Risk’

Supervisor: Prof. Dr. Jan A. Kregel

Opponent: Prof. Dr. Fernando J. Cardim Carvalho

Defense: 22 October 2010

Abstract: Portfolio diversification carried out by individual financial market participants plays a central role in creating systemic risk and boom-bust cycles in financial markets. Diversification reduces perceived risk and in turn increases leverage and asset prices. High interconnectedness as a result of portfolio diversification increases the correlation of returns across market participants and causes procyclical effects that strengthen both upward and downward asset price movements, though in a highly asymmetric manner. Importantly, this seemingly irrational boom and bust cycle is endogenous to financial markets, but its amplitude is highly dependent on how diversified market participants are. We use a simulation to illustrate how it plays out.

Keywords: Financialization, Systemic risks, financial fragility and crisis.