CRYPTOCURRENCIES: HEDGING OR DIVERSIFYING TOOLS. SOME MIXED EVIDENCE

In finance, valuation of an investment vehicle is a difficult topic to approach. In theory, the dollar and any other currency issued and regulated by a government are fiat money and therefore have no intrinsic value. When it comes to commodities such as gold, their intrinsic value is not zero but most likely not as high as their price (Kiyotaki and Wright, 1989). As for cryptocurrencies, Tether is the only one resembling a fiat currency as its value is pegged to the USD and does not diverge from 1 USD. The other cryptocurrencies can be seen as a hybrid between a commodity and a fiat money (Dyhrberg, 2016). Seeing the difficulty in attributing cryptocurrencies to a certain asset class, the question arises as to how their value is derived. It can be obtained from the benefits cryptocurrencies provide as an alternative monetary system. But the following related question is even more important: are cryptocurrencies a new, good investment opportunity? This issue can be investigated from the perspective of an institutional inverstor where diversification and hedging are of paramount importance. For those investors, the high volatility encompassing cryptocurrencies is surely excessive and therefore they are unwilling to invest significant amounts of capital. Considering this, cryptocurrencies seen as an investment opportunity can be confined to diversification and hedging purposes. Hedging capability can be differentiated in terms of a hedge, a diversifier and a safe heaven. A hedge is defined as an asset that exhibits zero or negative correlation with the price of another asset or portfolio. A diversifier is an asset that has a slight positive correlation with another asset. A safe heaven has the feature of showing insignificant or negative correlation in times of financial turmoil when its value remains quite stable and positive. Of course, investors are also interested in seeing whether cryptocurrencies increase their portfolio’s performance.

Focusing on Bitcoin, Litecoin and Ripple and three asset classes (stocks, bonds and gold) , Saerbeck, Silva and Wong (University of Amsterdam, 2018) investigate hedging capabilities of cryptocurrencies analyzing the pairwise correlations between the returns of six above-mentioned assets based on the dynamic conditional correlation model (DCC – Engle, 2012). The DCC model has the ability to capture time varying correlations across returns of the asset classes with few biases.

After that they also investigate the investment potential of cryptocurrencies by including them in bivariate portfolios using the conditional hedging strategy method (Kroner and Sultan, 1993) where the ratio between the conditional covariances between cryptocurrencies and one of the three asset class and the conditional variance of the cryptocurrency in turn analyzed is used to obtain the dynamic hedge ratio which minimizes risk.

The analysis carried out with data between August 2013 and January 2018 show that Bitcoin and Litecoin are slightly negatively correlated with all the three asset classes, while Ripple is slightly positively correlated. Furthermore these correlations seemed to fluctuate more at the inception of the sample period with respect to its end. Following the estimation of pairwise DCC, the extent to which cryptocurrencies can be used as a hedge is investigated. The results show a zero or negative correlation for Bitcoin: thus the authors conclude that this cryptocurrency can be used as a hedge for stocks, bonds and gold and a safe heaven for stocks only when their returns are extremely low . The same results are found for Litecoin (i.e. a good hedge for the three asset classes) even though it cannot be used as a safe heaven, while for Ripple the opposite is true: it is a diversifier with respect to the other three assets. Furthermore Ripple is found to be positively correlated with the SP500 returns when they are at their lower 5% quantile. In other words, in times of stock market stress it is unwisely to use it as a safe heaven. Of course these opposite results depend on the different characteristics of Ripple which is a tool for banks’ payment networks without miners.

Despite Bitcoin and Litecoin potentially being a hedge tool, are they actually able to reduce risks and/or improve returns for an investment portfolio? The estimated dynamic pairwise hedge ratios are all negative for Bitcoin and Litecoin (except the pair Bond-Bitcoin): this means that their values move in opposite directions: thus a portfolio manager should take a long position in cryptocurrencies in order to hedge a long position in the asset chosen. In the other four cases (Ripple versus all the three asset classes and Bitcoin versus Bond) the estimated coefficient is positive, meaning that a short (long) position should be taken in cryptocurrencies when a long (short) position is held in an asset class. Moreover those dynamic hedge ratios are “mean reverting”, i.e. they are statistically stationary. What does that mean in practice? It means that the impact of shocks usually given by news will eventually become negligible with the passing of time.

Unfortunately, when the dynamic hedge ratios are applied to the (hedged) bivariate portfolios variances increase compared to those of the univariate portfolios (i.e. those of the three asset classes). This negative hedging effectiveness (i.e. the fact that they always add variance to a minimum variance portfolio) comes to no surprise, seen the high levels of cryptocurrencies’ intrinsic volatility. Anyway higher Sharpe Ratios are achieved with respect to bonds and gold but not stocks, implying that (daily) high returns cannot always be obtained no matter the benchmark be.

¹⁾ Stock returns are measured through the SP500 index, bonds’ through and gold through the Merrill Lynch World Sovereign Bond index and gold through the Gold Bullion London Bullion Market US$/Troy Ounce.
²⁾ i.e. each cryptocurrency and asset combinations like, say, Bitcoin-gold, Litecoin-bonds or Ripple-stocks.
³⁾ At the first percentile of their distribution.

Literature References

Dyhrberg, A.H., 2016. Hedging capabilities of bitcoin. Is it the virtual gold? Finance Research Letters 16 139-144
Engle, R., 2012. Dynamic Conditional Correlation. Journal of Business & Economic Statistics 339-350

Kiyotaki, N., Wright R., 1989. On Money as a Medium of Exchange. Journal of Political Economy, 97(4), 927-954

Kroner, K. F., Sultan J., 1993. Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures. The Journal of Financial and Quantitative Analysis, 535-551

Saerkbeck D., Delgado Silva D., Song Wong W., 2018. Cryptocurrency: A New Investment Opportunity? An Investigation of the Hedging Capability of Cryptocurrencies and Their Influence on Stock, Bond and Gold Portfolios