THE APPLICATION OF CRYPTOCURRENCIES FOR HEDGING AND DIVERSIFICATION OF INVESTMENT PORTFOLIOS
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Introduction - 9 -
Chapter 1. Theoretical review - 11 -
1.1 About studied cryptocurrencies - 11 -
1.2 Definitions of diversifier, weak hedge, and strong hedge - 14 -
1.3 Previous studies in the field - 14 -
1.4 Research gap and hypotheses - 18 -
Chapter 2. Methodology - 20 -
2.1 Data - 20 -
2.2 Variables - 22 -
2.3 Model choice - 22 -
2.4 Algorithm of analysis - 24 -
2.4.1 Stationarity check - 24 -
2.4.2 Testing for ARCH effects - 24 -
2.4.3 Model construction and choice of the most suitable one - 25 -
2.4.4 Model validity check - 26 -
Chapter 3. Results and discussion - 28 -
3.1 Descriptive statistics - 28 -
3.2 Econometric models - 33 -
3.2.1 Model for Bitcoin - 33 -
3.2.2 Model for Ethereum - 38 -
3.2.3 Model for BNB - 44 -
3.3 Portfolios construction and analysis - 50 -
3.3.1 Portfolios with MSCI World (Developed Markets) Index - 51 -
3.3.2 Portfolios with MSCI Emerging Markets Index - 52 -
3.3.3 Portfolios with MSCI Russia Index - 53 -
3.4 Discussion - 54 -
3.4.1 Summary of results - 54 -
3.4.2 Academic implications - 54 -
3.4.3 Practical implications - 55 -
3.4.4 Limitations and further research directions - 55 -
Conclusion - 57 -
References - 59 -
Chapter 1. Theoretical review - 11 -
1.1 About studied cryptocurrencies - 11 -
1.2 Definitions of diversifier, weak hedge, and strong hedge - 14 -
1.3 Previous studies in the field - 14 -
1.4 Research gap and hypotheses - 18 -
Chapter 2. Methodology - 20 -
2.1 Data - 20 -
2.2 Variables - 22 -
2.3 Model choice - 22 -
2.4 Algorithm of analysis - 24 -
2.4.1 Stationarity check - 24 -
2.4.2 Testing for ARCH effects - 24 -
2.4.3 Model construction and choice of the most suitable one - 25 -
2.4.4 Model validity check - 26 -
Chapter 3. Results and discussion - 28 -
3.1 Descriptive statistics - 28 -
3.2 Econometric models - 33 -
3.2.1 Model for Bitcoin - 33 -
3.2.2 Model for Ethereum - 38 -
3.2.3 Model for BNB - 44 -
3.3 Portfolios construction and analysis - 50 -
3.3.1 Portfolios with MSCI World (Developed Markets) Index - 51 -
3.3.2 Portfolios with MSCI Emerging Markets Index - 52 -
3.3.3 Portfolios with MSCI Russia Index - 53 -
3.4 Discussion - 54 -
3.4.1 Summary of results - 54 -
3.4.2 Academic implications - 54 -
3.4.3 Practical implications - 55 -
3.4.4 Limitations and further research directions - 55 -
Conclusion - 57 -
References - 59 -
This work is devoted to the cryptocurrencies and studying prospects of their applicability for hedging and diversification of investment portfolio. Cryptocurrency is a digital currency, for which the encryption techniques are used to control the emission of new currency units and which transactions are verified, and records maintained by a decentralized system using cryptography, rather than by a centralized authority. (Schueffel, Groeneweg, & Baldegger, 2019) In simple words, decentralized system is a network of myriad of computers, running separate copies of the same program.1
The cryptocurrencies market is on rise, as can be confirmed either by high growth of total market capitalization of cryptocurrencies (CAGR equal to ~29.5% for a period from 1 January 2018 till 25 February 2022) market and by wide coverage in the news. On the moment of writing this paper, total market capitalization of cryptocurrencies amounts to $1.72 trillion USD consisting of 15,617 crypto tokens traded on 446 exchanges worldwide.2 Furthermore, the rapid growth of cryptocurrency owners says that there are more and more potential cryptocurrency investors coming, thus underlining the importance and actuality of studying cryptocurrencies. Moreover, if the current growth rate is extrapolated in 2022, the global number of crypto users can reach even a figure of 1 billion by the end of 2022. (Hon, Wang, Bolger, Wu, & Zhou, 2022)
While other financial assets properties are widely studied, the cryptocurrencies, as a new financial instrument provides a lot of ground for research, being the source of disrupt in modern financial industry. Cryptocurrencies are different from stock indices and commodities in terms of higher volatility and high tail risks (Feng, Wang, & Zhang, 2018). High volatility leads to higher uncertainty about future prices of cryptocurrencies, making them quite a risky financial instrument for investors. In context of raising interest in cryptocurrencies and active growth of cryptocurrency wallets’ holders it becomes more and more important to provide more ground for decisions concerning adding cryptocurrencies to investor portfolio. This research is aimed to study the association between Bitcoin, Ethereum and BNB cryptocurrencies’ returns and external variables in the role market indices returns to understand whether each analyzed cryptocurrency has diversifier or weak/strong hedge property. In this field of research, the number of works is even smaller, emphasizing the research gap.
Research question of this paper is: “Do selected cryptocurrencies have diversifier, weak hedge or strong hedge properties for world equity indices?”. Research goal is formulated as follows: “To identify whether the selected cryptocurrencies have diversifier, weak hedge or strong hedge properties for selected stock market indices”. The formulated research objectives are as follows:
1. To get an understanding of current state of research in the field by reading and analyzing existing academic papers.
2. To define the set of cryptocurrencies and equity indices for analysis and to set a timeframe for a dataset.
3. To collect data and form a dataset for analysis.
4. To choose the econometric model for performing analysis and substantiate the choice.
5. To conduct an analysis and discover which properties selected cryptocurrencies demonstrate with respect to selected equity indices.
6. To demonstrate how adding cryptocurrency to an investor portfolio mimicking each stock market index affects risk-adjusted performance.
7. To explain the academic and practical implications of obtained results to underline the usefulness of research for its audience.
Considering the applicability of results obtained in this paper, the potential investor should gain deeper understanding of the effects of including studied cryptocurrencies in investment portfolios.
The novelty of work is supported by including not only Bitcoin and Ethereum, which mostly were the focus of previous studies, but also BNB (Binance cryptocurrency), and also adding the MSCI Russia index returns as independent variable (which will be especially interesting for investors in Russian stock market) besides updating the set of generally used indices with the new ones: MSCI World Index (devoted to developed markets) and MSCI Emerging markets index (devoted to emerging markets) returns. Adding these indices provides more detailed view on studied properties of cryptocurrencies separately for developed, emerging markets, and for Russian market. Finally, the more recent data is used (also covering the COVID-19 pandemic period), making this work more up to date.
The cryptocurrencies market is on rise, as can be confirmed either by high growth of total market capitalization of cryptocurrencies (CAGR equal to ~29.5% for a period from 1 January 2018 till 25 February 2022) market and by wide coverage in the news. On the moment of writing this paper, total market capitalization of cryptocurrencies amounts to $1.72 trillion USD consisting of 15,617 crypto tokens traded on 446 exchanges worldwide.2 Furthermore, the rapid growth of cryptocurrency owners says that there are more and more potential cryptocurrency investors coming, thus underlining the importance and actuality of studying cryptocurrencies. Moreover, if the current growth rate is extrapolated in 2022, the global number of crypto users can reach even a figure of 1 billion by the end of 2022. (Hon, Wang, Bolger, Wu, & Zhou, 2022)
While other financial assets properties are widely studied, the cryptocurrencies, as a new financial instrument provides a lot of ground for research, being the source of disrupt in modern financial industry. Cryptocurrencies are different from stock indices and commodities in terms of higher volatility and high tail risks (Feng, Wang, & Zhang, 2018). High volatility leads to higher uncertainty about future prices of cryptocurrencies, making them quite a risky financial instrument for investors. In context of raising interest in cryptocurrencies and active growth of cryptocurrency wallets’ holders it becomes more and more important to provide more ground for decisions concerning adding cryptocurrencies to investor portfolio. This research is aimed to study the association between Bitcoin, Ethereum and BNB cryptocurrencies’ returns and external variables in the role market indices returns to understand whether each analyzed cryptocurrency has diversifier or weak/strong hedge property. In this field of research, the number of works is even smaller, emphasizing the research gap.
Research question of this paper is: “Do selected cryptocurrencies have diversifier, weak hedge or strong hedge properties for world equity indices?”. Research goal is formulated as follows: “To identify whether the selected cryptocurrencies have diversifier, weak hedge or strong hedge properties for selected stock market indices”. The formulated research objectives are as follows:
1. To get an understanding of current state of research in the field by reading and analyzing existing academic papers.
2. To define the set of cryptocurrencies and equity indices for analysis and to set a timeframe for a dataset.
3. To collect data and form a dataset for analysis.
4. To choose the econometric model for performing analysis and substantiate the choice.
5. To conduct an analysis and discover which properties selected cryptocurrencies demonstrate with respect to selected equity indices.
6. To demonstrate how adding cryptocurrency to an investor portfolio mimicking each stock market index affects risk-adjusted performance.
7. To explain the academic and practical implications of obtained results to underline the usefulness of research for its audience.
Considering the applicability of results obtained in this paper, the potential investor should gain deeper understanding of the effects of including studied cryptocurrencies in investment portfolios.
The novelty of work is supported by including not only Bitcoin and Ethereum, which mostly were the focus of previous studies, but also BNB (Binance cryptocurrency), and also adding the MSCI Russia index returns as independent variable (which will be especially interesting for investors in Russian stock market) besides updating the set of generally used indices with the new ones: MSCI World Index (devoted to developed markets) and MSCI Emerging markets index (devoted to emerging markets) returns. Adding these indices provides more detailed view on studied properties of cryptocurrencies separately for developed, emerging markets, and for Russian market. Finally, the more recent data is used (also covering the COVID-19 pandemic period), making this work more up to date.
In closing, this research paper is aimed at identification whether the studied cryptocurrencies (Bitcoin, Ethereum, BNB) have diversifier, weak hedge or strong hedge properties for selected stock market indices: MSCI Developed Markets Index, MSCI Emerging Markets Index and MSCI Russia Index. Bitcoin, Ethereum and BNB were analyzed through the perspective of hypotheses stated in “Research problem, goal, objectives, and hypotheses” section paper and the answer to the research question for each studied cryptocurrency was obtained. In brief:
• Bitcoin can serve as a diversifier to the portfolio mimicking MSCI Developed Markets Index, as a weak hedge to the portfolio mimicking MSCI Emerging Markets Index and as a weak hedge to the portfolio mimicking MSCI Russia Index.
• Ethereum can serve as a diversifier to the portfolio mimicking MSCI Developed Markets Index, as a weak hedge to the portfolio mimicking MSCI Emerging Markets Index. Ethereum also can serve as a diversifier to the portfolio mimicking MSCI Russia Index.
• BNB can serve as a diversifier to the portfolio mimicking MSCI Developed Markets Index, as a weak hedge to the portfolio mimicking MSCI Emerging Markets Index and as a weak hedge to the portfolio mimicking MSCI Russia Index.
Moreover, to get the understanding of how adding each cryptocurrency to investor portfolio represented by each stock market index affects risk-adjusted performance, portfolios combined of a cryptocurrency with each stock market index were constructed and analyzed. In brief, risk- adjusted performance of portfolios mimicking MSCI Developed Markets Index, MSCI Emerging Markets Index and MSCI Russia Index was improved by adding any of studied cryptocurrencies, but portfolios with BNB demonstrated the best risk-adjusted performance.
The novelty of work is supported by including BNB cryptocurrency. Novelty of this work also lies in using MSCI World, MSCI Emerging Markets and MSCI Russia indices as independent variables in applied model, which ultimately provides a detailed view on studied properties of cryptocurrencies separately for developed, emerging markets, and for Russian market. Finally, the more recent data is used which covers pandemic period.
From an academic viewpoint, this paper fulfills the research gap and adds new experience and results into emerging field of research of cryptocurrencies and their possible application as an investment tool. From a practical viewpoint, results on the classification of cryptocurrencies as a diversifier or a weak hedge provide to investors more understanding of how cryptocurrencies’ returns are associated with studied stock market indices returns. Portfolios construction and analysis provides an extended view on how adding each cryptocurrency to portfolios mimicking the studied stock market indices affects risk-adjusted performance. Therefore, the potential investor gains an even more complete picture of the effects of including studied cryptocurrencies in the investment portfolio.
As for further research directions, there are several recommendations. It would be useful to consider extended timeframe. It would be also beneficial to add a perspective on weekly or even monthly returns in future research (especially when longer timeframe of data will be available). One of further research directions is to exploit other MSCI indices or even to apply not MSCI Indices, but national equity indices (e.g., RTSI for Russia, CSI300 for China, FTSE 100 for United Kingdom, etc.) for studying the diversification or weak/strong hedging properties of cryptocurrencies against those indices. In conclusion, only Bitcoin, Ethereum and BNB were studied, which provides wide set of future directions of research in terms of the choice of studied cryptocurrencies.
• Bitcoin can serve as a diversifier to the portfolio mimicking MSCI Developed Markets Index, as a weak hedge to the portfolio mimicking MSCI Emerging Markets Index and as a weak hedge to the portfolio mimicking MSCI Russia Index.
• Ethereum can serve as a diversifier to the portfolio mimicking MSCI Developed Markets Index, as a weak hedge to the portfolio mimicking MSCI Emerging Markets Index. Ethereum also can serve as a diversifier to the portfolio mimicking MSCI Russia Index.
• BNB can serve as a diversifier to the portfolio mimicking MSCI Developed Markets Index, as a weak hedge to the portfolio mimicking MSCI Emerging Markets Index and as a weak hedge to the portfolio mimicking MSCI Russia Index.
Moreover, to get the understanding of how adding each cryptocurrency to investor portfolio represented by each stock market index affects risk-adjusted performance, portfolios combined of a cryptocurrency with each stock market index were constructed and analyzed. In brief, risk- adjusted performance of portfolios mimicking MSCI Developed Markets Index, MSCI Emerging Markets Index and MSCI Russia Index was improved by adding any of studied cryptocurrencies, but portfolios with BNB demonstrated the best risk-adjusted performance.
The novelty of work is supported by including BNB cryptocurrency. Novelty of this work also lies in using MSCI World, MSCI Emerging Markets and MSCI Russia indices as independent variables in applied model, which ultimately provides a detailed view on studied properties of cryptocurrencies separately for developed, emerging markets, and for Russian market. Finally, the more recent data is used which covers pandemic period.
From an academic viewpoint, this paper fulfills the research gap and adds new experience and results into emerging field of research of cryptocurrencies and their possible application as an investment tool. From a practical viewpoint, results on the classification of cryptocurrencies as a diversifier or a weak hedge provide to investors more understanding of how cryptocurrencies’ returns are associated with studied stock market indices returns. Portfolios construction and analysis provides an extended view on how adding each cryptocurrency to portfolios mimicking the studied stock market indices affects risk-adjusted performance. Therefore, the potential investor gains an even more complete picture of the effects of including studied cryptocurrencies in the investment portfolio.
As for further research directions, there are several recommendations. It would be useful to consider extended timeframe. It would be also beneficial to add a perspective on weekly or even monthly returns in future research (especially when longer timeframe of data will be available). One of further research directions is to exploit other MSCI indices or even to apply not MSCI Indices, but national equity indices (e.g., RTSI for Russia, CSI300 for China, FTSE 100 for United Kingdom, etc.) for studying the diversification or weak/strong hedging properties of cryptocurrencies against those indices. In conclusion, only Bitcoin, Ethereum and BNB were studied, which provides wide set of future directions of research in terms of the choice of studied cryptocurrencies.
