Risk Exposures in Cryptocurrency Markets

The dominant view between market participants and commentators (often, an instinctive reflection of the media hype surrounding the surge of Bitcoin’s valuation) is that cryptocurrencies may represent a new asset class, spanning risks and payoffs sufficiently different from traditional ones. As a result, one question has loomed in the mind of financial analysts and investors: are they a novel, innovative asset class potentially segmented away —i.e. driven by alternative economic forces and factors — from other, traditional asset classes?

Assuming cryptocurrencies are segmented from traditional asset classes has two main implications. On the one hand, when an asset class is separated from traditional investment vehicles in terms of its risk-return profile it means we understand less precisely which factors drive the dynamics of risk and returns. This adds complexity for investors and portfolio managers who often cannot rely on standard valuation tools to understand the fundamental value of cryptocurrencies. On the other hand, the fact that an asset class is segmented away from traditional investments means that it has the potential to offer large and persistent diversification opportunities.

As a result, the fact that cryptocurrencies may or not be separated from traditional sources of yield, such as equity, commodity, fixed income and foreign exchange, turns out to be an issue of first order importance for investors and market participants interested in cryptocurrency trading.

A recent research piece produced by Dr Daniele Bianchi (Queen Mary, University of London), Massimo Guidolin (Bocconi University, Milan) and Manuela Pedio (Bicocca University, Milan) contributes to a further understanding of the value of investing in cryptocurrencies in addition to standard asset classes, and within the context of a typical diversified portfolio allocation.

By using a complex dynamic econometric setting, the authors look at the time variation in the exposures of major cryptocurrencies to stock market risk factors (namely, the six Fama French factors), to precious metal commodity returns, and to cryptocurrency-specific risk-factors (namely, crypto-momentum, a sentiment index based on Google searches, and supply factors, i.e., electricity and computer power).

The main empirical results suggest that cryptocurrencies are not systematically exposed to stock market factors, precious metal commodities or supply factors, with exception of some occasional spikes of the coefficients during the sample. On the contrary, they display a time-varying but significant exposure to a sentiment index and to crypto-momentum. Despite lack of predictability compared to traditional asset classes, cryptocurrencies display considerable diversification power and, as such, can generate slightly higher Sharpe ratios and certainty equivalent returns within the context of a typical portfolio. More precisely, in a recursive asset allocation experiment, the authors show that cryptocurrencies are able to generate considerable investor value (especially when measured in terms of ex-post Sharpe ratios) when they are added to otherwise traditional asset menus of cash, corporate bonds, US and international stocks, and long-short exchange rate positions.

Interestingly, the value of cryptocurrencies cannot be reduced only to the fact the investors may have access to long positions in Bitcoin, in the sense that also other major cryptocurrencies, such as Ethereum, Litecoin, and Ripple appear to generate substantive investor value when they are added to Bitcoin and other traditional assets.

The complete paper is available upon request from the corresponding author at d.bianchi@qmul.ac.uk.


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