Cryptocurrency Returns, Diversification, and Portfolio Risks

# Something fundamentally different about cryptocurrencies?


# Something fundamentally different about cryptocurrencies?












You read a lot about cryptocurrencies these days, especially bitcoin.

My question: Do you see something fundamentally different about them compared to other asset classes, i.e. other currencies, from a quantitative point of view?

If yes, could you give some good references which discuss those characteristics?

## Answer by Quswar Abid (score 3, accepted)

https://quant.stackexchange.com/a/36346

There is something very fundamental to Cryptocurrencies, especially the one you want to talk about, i.e. Bitcoin. I suggest you a very good reading, "Academic Pedigree of Cryptocurrency." There is a method of registering every transaction happening on Bitcoin Peer-to-Peer reviewed distributed network, which is called a "Public Ledger." Every Miner is basically a ledger, who earns a reward by the distributed network for recording certain number of transactions, collectively known as a 'Block.' This is why miners' startup are usually referred to as "Block Chain."

In our normal currency system, the "Ledger Work" is done through Banks. You might have heard (if I am not Wrong!) that a check is a ledger, but a private ones. This is why Banks work by charging you, because they have to power up the system with your money. In Bitcoin or any other CC network, the work is not only public, but also done without any intermediate structure. So, You can directly send your money (bitcoins,) and not worry about it. It is secure! Than, every transactions is on public ledger, so every user with a unique user key, and pass key can have access to his bitcoins, and privacy of this ownership is entirely dependent on user. You wanna publish you crypto-wealth, well! Go On! But you don't really have to do this.

Now, you will start to connect the dots, and make a whole picture that explains the difference itself. Our everyday Banking Structures are fueled by a whole banking, and financial infrastructure, which is than either controlled or governed by some central department, for which you are charged. Obviously, Money is Fuel for Economy. But as you see, Bitcoin have no central controlling system, even its inventor (named as Satoshi Nakamuto) have no control over it. Now, let's discuss the fluctuating price for such CC, like Bitcoin. Its highly unstable prices attract our attention, when we get to hear that people with thousand of bitcoins are now Millionaires, just because they've mined a lot in past. The truth is, that this currency is still experimental. Its price is totally governed by the exchange rates of markets, and totally determined on the basis of Demand & Supply of Market. One bank added a support for FOREX in Bitcoins, and prices climbed up to USD 5,000. Sudden rush to sell increased the supply in market, and the prices went back to USD 3,000. There will be a time, when its prices will get stable, but for that to happen, we need a lot more people to adopt CryptoCurrency as their common transaction medium.

## Answer by vonjd (score 7)

https://quant.stackexchange.com/a/37468

Status of this answer: latest update July 7, 2022.

There is a new paper out which is quite interesting and which basically says that cryptocurrencies are indeed a new asset class, potentially useful as a diversifier of conventional asset classes:

Corbet, Shaen and Meegan, Andrew and Larkin, Charles James and Lucey, Brian M. and Yarovaya, Larisa, Exploring the Dynamic Relationships between Cryptocurrencies and Other Financial Assets (November 13, 2017). Available at SSRN: https://ssrn.com/abstract=3070288

Abstract We analyse, in the time and frequency domains, the relationships between three popular cryptocurrencies and a variety of other financial assets. We find evidence of the relative isolation of these assets from the financial and economic assets. Our results show that cryptocurrencies may offer diversification benefits for investors with short investment horizons. Time variation in the linkages reflects external economic and financial shocks.

Another new paper states that "investors should view cryptocurrencies as risky, competing and somewhat illiquid bets on potential improvements over conventional ways of doing business worldwide, not stores of value." (Source: https://www.cxoadvisory.com/30892/currency-trading/cryptocurrency-primer/):

Kim, Seoyoung and Sarin, Atulya and Virdi, Daljeet, Crypto-Assets Unencrypted (January 31, 2018). Journal of Investment Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3117859

Abstract With the recent surge in crypto-activity, a natural question arises as to what exactly a “cryptocurrency” is and how to value and assess these digital assets. In this paper, we provide an overview of the history and technology underlying cryptocurrencies. We also present information on the volume, size, and volatility of this emerging asset class, which we compare to major fiat currencies and commodities. Finally, we provide a framework for valuing crypto-assets, discuss the still-evolving regulatory environment for this asset class, and discuss the mechanics of investing in cryptocurrencies.

Another paper finds that "the body of crypto-asset research, based on arguably immature market data, suggests considerable obstacles to widespread investment and adoption." (source: https://www.cxoadvisory.com/31066/currency-trading/crypto-asset-research-survey/):

Corbet, Shaen and Lucey, Brian M. and Urquhart, Andrew and Yarovaya, Larisa, Cryptocurrencies as a Financial Asset: A Systematic Analysis (March 18, 2018). Available at SSRN: https://ssrn.com/abstract=3143122 or http://dx.doi.org/10.2139/ssrn.3143122

Abstract This paper provides a systematic review of the empirical literature on the major topics that have been associated with the market for cryptocurrencies since their development as a financial asset in 2009. Despite astonishing price appreciation in recent years, cryptocurrencies have been subjected to accusations of pricing bubbles central to the trilemma that exists between regulatory oversight, the potential for illicit use through it's anonymity within a young underdeveloped exchange system, and infrastructural breaches influenced by the growth of cyber criminality. Each influence the perception of the role of cryptocurrencies as a trustworthy credible investment asset class and legitimate of value.

The next paper "indicates that investors may benefit from adding crypto-assets to their portfolios, with even a fixed 1% allocation offering material Sharpe ratio improvements." (Source: https://www.cxoadvisory.com/31159/currency-trading/diversify-with-crypto-assets):

Krueckeberg, Sinan and Scholz, Peter, Cryptocurrencies as an Asset Class? (April 14, 2018). Available at SSRN: https://ssrn.com/abstract=3162800 or http://dx.doi.org/10.2139/ssrn.3162800

Abstract Cryptocurrencies show characteristics of a distinct asset class based on strong internal correlation, an absence of correlation with any traditional asset class as well as strong market liquidity, while market stability has room for improvement. We find that for investment purposes cryptocurrencies can be distinguished into cryptographic coins and tokens. Adding a 1% allocation of cryptocurrencies to traditional portfolio structures leads to significant and persistent risk weighted outperformance. These results support the careful introduction of cryptocurrencies into the asset management mainstream.

The next paper "indicates that crypto-assets have little or no relationships to traditional asset classes, exhibit some predictability based on short-term momentum and investor attention and are more important (positively or negatively) for some industries than others." (Source: https://www.cxoadvisory.com/31471/currency-trading/crypto-asset-risks-and-returns):

Liu, Yukun and Tsyvinski, Aleh, Risks and Returns of Cryptocurrency (August 6, 2018). Available at SSRN: https://ssrn.com/abstract=3226952 or http://dx.doi.org/10.2139/ssrn.3226952

Abstract We establish that the risk-return tradeoff of cryptocurrencies (Bitcoin, Ripple, and Ethereum) is distinct from those of stocks, currencies, and precious metals. Cryptocurrencies have no exposure to most common stock market and macroeconomic factors or to the returns of currencies and commodities. In contrast, we show that the cryptocurrency returns can be predicted by factors which are specific to cryptocurrency markets – there is a strong time-series momentum effect and proxies for investor attention strongly forecast cryptocurrency returns. Finally, we create an index of exposures to cryptocurrencies of 354 industries in the US and 137 industries in China.

The next paper concludes that their "correlation profile suggests that cryptocurrencies do not offer protection for investors with short horizons." Over long term horizons their correlation profile is unclear. "Investors require an annualized expected return of at least 30% to support allocation to cryptocurrencies."

Czasonis, Megan and Kritzman, Mark and Pamir, Baykan and Turkington, David, The Role of Cryptocurrencies in Investor Portfolios (March 15, 2021). MIT Sloan Research Paper No. 6418-21, Available at SSRN: https://ssrn.com/abstract=3806212 or http://dx.doi.org/10.2139/ssrn.3806212

Abstract The role of cryptocurrencies as a vehicle for speculation has been well established. However, it is less clear if cryptocurrencies can also serve to manage risk. The authors seek to determine the diversification potential of cryptocurrencies both for short and long horizons. For short horizons, they estimate correlations that consider the direction and magnitude of returns for relevant asset classes, rather than focus on full-sample correlations, as is customary. For long horizons, they compute “single period correlations,” which capture the extent to which cryptocurrencies move synchronously or drift apart from other assets over an investor’s horizon. They also identify utility-maximizing allocations to cryptocurrencies directly from historical return samples that account for all features of the data as well as more nuanced preferences than typically assumed.

The next paper shows that while gold arguably has some value as inflation/purchasing power hedge and store of value over a very long sample period, the short bitcoin track record does not support belief that it is inflation hedge, store of value or safe haven.

Erb, Claude B., Bitcoin is Exactly Like Gold Except When it Isn't (December 14, 2020). Available at SSRN: https://ssrn.com/abstract=3746997 or http://dx.doi.org/10.2139/ssrn.3746997

Abstract Bitcoin has been described as digital gold. Bitcoin is exactly like gold except when it isn’t. Over millennia, gold has gained a questionable reputation as an inflation hedge, a store of value and a safe haven. Gold’s price can arguably be decomposed into a “golden constant” fair price and a fair price deviation. Bitcoin has no track record as an inflation hedge, a store of value and a safe haven. Bitcoin’s price can arguably be decomposed into a questionable “bitcoin network” fair price and a fair price deviation. Both bitcoin and gold are about 50% above their “fair prices”.

The last paper shows that evidence suggests that investors can reasonably include risk-managed crypto-asset positions in broader portfolios.

Harvey, Campbell R. and Abou Zeid, Tarek and Draaisma, Teun and Luk, Martin and Neville, Henry and Rzym, Andre and van Hemert, Otto, An Investor’s Guide to Crypto (May 31, 2022). Available at SSRN: https://ssrn.com/abstract=4124576 or http://dx.doi.org/10.2139/ssrn.4124576

Abstract We provide practical insights for investors seeking exposure to the growing cryptocurrency space. Today, crypto is much more than just bitcoin, which historically dominated the space but accounted for just a 21% share of total crypto trading volume in 2021. We discuss a wide variety of tokens, highlighting both their functionality and their investment properties. We critically compare popular valuation methods. We contrast buy-and-hold investing with more active styles. We only deem return data from 2017 representative, but the use of intraday data boosts statistical power. Underlying crypto performance has been notoriously volatile, but volatility-targeting methods are effective at controlling risk, and trend-following strategies have performed well. Crypto assets display a low correlation with traditional risky assets in normal times, but the correlation also rises in the left tail of these risky assets. Finally, we detail important custody and regulatory considerations for institutional investors.