EXAMINING Cryptocurrency profiles
As the world enters the 21st century, the effectiveness of traditional financial systems is being reassessed. The first cryptocurrency emerged when Satoshi Nakamoto invented the Bitcoin in 2009, a decentralised digital currency, with a fixed money supply, that enables peer-to-peer transactions to take place without the need of intermediaries. The Bitcoin rose steadily despite fluctuations in 2014 and 2015; yet, it was not until 2017 that it surpassed $1,000. 2017 saw Bitcoin lead an unprecedented and the longest rally by cryptocurrencies to date. (CoinDesk, 2020) Its price soared from $5,000 in October 2017, peaking at $19,783 on December 17th 2017. However, five days later, it experienced a plunge of 45%, that of which continued throughout 2018.
Having lost more than 80% of its market value since the December spike, Bitcoin stood at less than $3,500 in November 2018; other cryptocurrencies followed suit. According to critics, it was akin to the Tulipmania of 17th century Holland (Popper, 2019) - a bursting financial bubble. On the other hand, some see the sharp decline as a natural response to the increase; unlike the Dollar or Euro, having a fixed money supply allowed the Bitcoin to refind its price equilibrium rapidly. We elucidate this by comparing the price change of the Euro (EUR) exchanged with the US Dollar (USD) to the price change of the cryptocurrency Bitcoin (BTC) exchanged with the US Dollar (USD) in the form of two graphs shown overleaf: EUR to USD and BTC to USD.
Contrasting them, we see that the exchange rate between two national currencies EUR-USD is less volatile than the BTC-USD. This can be explained by the difference in nature of the two types of currencies, with cryptocurrencies being decentralised and the national currencies often being intervened by their respective governments. Regardless, it is wise to question the contribution and volatile performance of this new device as technology continues to advance, and cryptocurrency gains traction with more people.
In 2008 the financial crisis struck, causing halts to major global economies, skyrocketing unemployment rates and tamping down stock values; once a dominant financial institution Lehman Brothers went bankrupt. The aftermath of this recession brought light to the instability of our modern banking systems, and one year later, the first ever digital currency - Bitcoin - was launched. Although there seems to be strong links between the financial crisis and this groundbreaking invention, whether one did cause the other is unclear. Nevertheless, as Professor David Yermack of New York University put it during an interview with Marketwatch, the “timing of its launch could only have helped attract users.” (Hankin, 2018)
Following suit, more than 2000 cryptocurrencies emerged over the past decade. Investments in them have made people affluent, but, in other cases, have wiped off their fortunes. This was especially evident after the cryptocurrency crash of 2018, which reminded cryptocurrency holders of the 2008 financial crisis and amplified the potential pitfalls of investing in digital peer-to-peer currency. And this is also our primary reason to carry out this research. In the volatile settings of cryptocurrencies, we understand investors’ need to reduce risk, and, hence, this is why we place heavy emphasis on exploring a multitude of cryptocurrency portfolio arrangements that would minimise the effects of a bear market.
Here is a relist of the cryptocurrency portfolios that we examine in this study: equal weights, variance, correlation, and covariance. It is important to note that expected returns are not weighted in our final evaluation of these portfolios, as our risk-based methods may lead to possible errors when estimating expected returns, that of which would harm the accuracy of our results.
Although there has not been a significant amount of research made on the topic of cryptocurrency portfolios, there are abundant studies on portfolio optimisations for traditional assets. Some of these findings prove useful and relatable to our study, offering us insight into the topic of portfolio management; we will outline them in the section below. To restate the research question of this study, we are examining different portfolio strategies to obtain a cryptocurrency portfolio that would offer the least amount of risk to its investor.
Our research would make a contribution to the literature of this field of study. This is because we base our study on four common portfolio strategies; however, we factor in diversification, which means that we run two different tests per strategy - one portfolio test with 4 cryptocurrencies and one with 20 cryptocurrencies. This step is to ensure that we cover the different factors that may affect the risk-reducing aptitude of a cryptocurrency portfolio, and using 4 common portfolio strategies allow our study to have a greater usage and contribution to ordinary cryptocurrency investors. Next, to further expand the scope of our study, we add the most risk-reducing cryptocurrency portfolio we found to a standard portfolio of ETF (Exchange-traded fund) to see whether the incorporation of cryptocurrencies that way would decrease the overall risk of the mixed portfolio.
Read the full research paper below!
By Yizhen (Tina) Kong, Patrick Ledoit, and Yibo (Bobby) Zhao
(Year 12 Students at Bangkok Patana School)