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Running Head: CRYPTOCURRENCY DIVERSIFICATION 1
CRYPTOCURRENCY DIVERSIFICATION 4
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Abstract
Legislative bodies, industry professionals, the media, and academics from various fields are finding cryptocurrency to be an intriguing subject. The study finds benefits to diversification when combining cryptocurrency with equities instruments. To see how cryptocurrencies contribute to diversification, three separate, independent experiments were carried out. The two studies’ results demonstrate that when cryptocurrencies are included in equities stock portfolios, they increase portfolio risk and yield higher returns.
According to the first experiment, cryptocurrencies raise average returns while lowering the risk level of equities portfolios. In keeping with theoretical models, adding more equity stocks to equity portfolios reduces portfolio risk (Burniske & White, 2020). The findings suggest that portfolio managers should take cryptocurrencies very seriously as a crucial component of the benefits of portfolio diversification. Future research may increase the samples of chosen portfolios containing equities from various stock indexes in order to examine the issue from a wider angle.
Parameters that Affect Diversification
Due to their tendency to be unrelated to conventional financial assets, cryptocurrencies provide benefits for diversification. According to conventional portfolio theories, increasing the number of stocks in traditional equity portfolios reduces risk exposure. The two primary input criteria that impact diversification risk are the correlation between assets and the volatility resulting from price fluctuations. The portfolio’s financial assets’ connection with one another affects the risk of diversification because a higher positive correlation raises that risk and vice versa.
Correlation
A statistical tool for determining the degree of the relationship between the relative movements of two or more variables is the correlation coefficient. Positively correlated variables travel in the same direction as negatively correlated variables, which have the opposite connection. It is ideal for the components of a well-diversified portfolio to be unrelated to one another. This implies that the other asset should lessen the impact of a price change in the first one. The study examines the relationship between Bitcoin’s excess returns and traditional asset returns as measured by a number of market indices, including the S&P 500, MSCI Emerging Market, Gold, and dollar index.
Making the correlation table has as its goal determining how closely Bitcoin is related to other assets. A higher correlation with other assets would indicate that Bitcoin is more likely to be impacted by the same variables as the other assets and would not provide a means of diversification. To evaluate the relationships between Bitcoin and other assets, a correlation table was created. Three months were chosen as the sample period, which ran from August 1 to October 31, 2018.
The relationships between different equities and different indexes were compared with Bitcoin. The average historical return for the securities was obtained using the Bloomberg terminal. We gathered the average historical return from Bitcoin using Bitcoincharts.com. Regression models were utilized to compute correlations, with Bitcoin and various securities’ average historical returns serving as the X and Y variables.
Volatility Levels
Assets without correlations should make up a well-diversified portfolio. This guarantees that the other elements should lessen the loss when one asset is damaged. The components of the portfolio should also be able to increase returns for that degree of risk. Due to a number of underlying reasons, the majority of traditional assets—stocks, money, bonds, and other instruments—are related. However, most assets’ values have fluctuated recently (particularly in the 2015–2016 period when a drop in the price of oil caused a global commodity price slump), while Bitcoin remained unaffected.
The fact that Bitcoin has relatively little association with other asset classes is what triggered this. Bitcoin has a very low correlation with fiat currencies and other assets from other parts of the world (as shown in the above table). In the chart below, the 30-day annualized return volatility is displayed for three different currencies: Chinese Yuan vs. USD (green line), Bitcoin vs. USD (blue line), and Litecoin vs. USD (purple line). Figure 2.0: 30-day annualized volatility of returns.
When compared to established currencies like the Chinese Yuan, the chart indicates that Bitcoin has a comparatively high return volatility. Given that Bitcoin increases uncertainty, it might not be a good idea to incorporate it in a portfolio. The graph does however demonstrate that Bitcoin is much less volatile than Litecoin, a rival cryptocurrency that is gaining traction. Furthermore, the graph indicates that Bitcoin’s volatility has been declining over the sample period, suggesting that the currency may eventually stabilize.
According to the observation, while Bitcoin’s volatility may pose a risk to the currency’s inclusion in a portfolio diversification strategy, its volatility is still much lower than that of other cryptocurrencies and it is on the decline which supports the inclusion of Bitcoin in the strategy. Furthermore, Bitcoin can attain even lower volatility and be a terrific tool for portfolio diversification as long as it continues to gain acceptance and use.
Conclusion
Over time, Bitcoin has grown in popularity. Its rapid value growth attracts many investors to speculate, which accounts for its appeal. While speculating may reduce systematic risks in a portfolio, it is not good for the long-term growth of the currency. Research indicates that there are extremely few correlations between Bitcoin and other stocks, and that portfolios that include Bitcoins generate higher returns than those that do not (Oosterlinck & Szafarz, 2022). Nonetheless, investing in Bitcoin carries certain dangers.
It is significant to remember that in comparison to other traditional currencies like the Chinese Yuan, Bitcoin still exhibits rather high return volatility. Investors should also be aware that excessive Bitcoin investment can reduce portfolio return. Finally, the decentralized nature of Bitcoin, along with illicit trading and a lack of certainty regarding network security may raise the risk associated with holding Bitcoin in a portfolio. According to the research, investing in Bitcoin can help diversify a portfolio, but because there are a lot of risks associated with it, investors should proceed with caution.
Reference
Briere, M., Oosterlinck, K., & Szafarz, A. (2022). Virtual currency, tangible return: Portfolio
diversification with bitcoin. Journal of Asset Management, 16(6), 365-373.
Burniske, C., & White, A. (2020). Bitcoin: ringing the bell for a new asset class. Ark Invest
(January 2017) ark invest.com/hubfs/1_Download_Files_ARKInvest/White_Papers/Bitcoin-Ringing-The-Bell-For-A-New-Asset-Class. pdf.
Carpenter, A. (2020). Portfolio diversification with Bitcoin. Journal of Undergraduate in
France, 1-27. Eisl, A., Gasser, S., & Weinmayer, K. (2015). Caveat Emptor: Does Bitcoin Improve Portfolio Diversification?.
