Risks and Rewards

Bauer Researcher Helps Investors Better Understand Risks and Rewards of Bitcoin

Published on January 20, 2022

Photo: James Yae

Research from the C. T. Bauer College of Business helps investors better understand the inherent benefit and risk of Bitcoin, the flagship cryptocurrency that debuted in 2008.

In a working paper under review by The Journal of Financial and Quantitative Analysis, Visiting Assistant Professor of Finance James Yae and Bauer College doctoral student George Tian clear up some of the mystery behind investing in digital currency that has no fixed value.

Contrary to common belief, institutional investors are now some of the biggest players in Bitcoin markets, the researchers write in "Sequential Learning, Asset Allocation, and Bitcoin Returns."

But when a pension fund or sovereign wealth fund includes Bitcoin in their portfolios, their goal is diversification, not price speculation, Yae says.

“They adjust their positions on Bitcoin in response to a correlation change, which is a common signal to them. For example, an increase in correlation, which means smaller diversification benefits, acts as a sell signal to all portfolio-optimizing investors, and Bitcoin experiences downward price pressure because of that.”

The researchers devised a method for predicting daily Bitcoin prices by anticipating institutional investors' trading patterns the day following investors’ time-varying diversification benefits.

Days with top 25 percent of correlation “decrease” have (on average) 0.7 percent higher next day returns than days with top 25 percent of correlation “increase,” they write.

“Conversely, you are paying higher prices for Bitcoin by that much if you are a portfolio-optimizing investor who monitors time-varying correlation and rebalances the portfolio accordingly. Furthermore, the same daily return-predictability pattern universally appears in global equity markets and other cryptocurrencies such as Ethereum, Ripple, and Litecoin,” Yae says.

“Bitcoin’s diversification benefit is real but highly volatile,” the researchers write. “Therefore, investors should never stop learning about the joint dynamics of assets, not only the profitability of the assets.”