Alternative Investments Valuation

Assignment 3: Cryptocurrencies

Cryptocurrencies are one of the latest forms of investable instruments that form part of
alternative investments. Alternative investments such as commodities, real estate, private equity,
hedge funds and cryptocurrencies have a lower historical correlation to conventional asset
classes such as bonds, stocks and cash due to which they serve as diversifiers in a portfolio of
investments. Cryptocurrencies are digital assets through which investors generate returns either
in form of cash or in form of other cryptocurrencies.

The ability of cryptocurrencies to convert to flat cash allows investors to incorporate these digital
assets into any portfolio. Like other alternative assets financial derivatives for cryptocurrencies
are beginning to flourish and have attracted a lot of investors. They unregulated alternative
investments characterized by high returns and volatilities that carry a common source of
systematic risk correlated with Bitcoin (largest cryptocurrency) returns.

Bitcoin is the most well known and earliest cryptocurrency and was the first to implement the
‘blockchain’ which solved the ‘double spend’ problem. Blockchain is an incorruptible digital
ledger of economic transactions which can be programmed to record virtually everything of
value. Most cryptocurrencies run on P2P (peer to peer) network in which transactions happen
directly between users without any intermediary. There are 2 types of tradable cryptocurrency
alternatives to Bitcoin i.e. coins and tokens, collectively referred to as altcoins. The issuing
process of most coins and tokens depends on their underlying software. Coins and tokens are
issued through a process called Initial Token Sales (ITS) more commonly known as Initial Coin
Offerings (ICO).

Following are the steps that in the process in an ICO: The ICO is publicized on different
aggregators (marketers of cryptocurrencies), these aggregators then attract investors or
participants to a document known as the ‘white paper’, which elaborates the purpose of offering
and use of underlying funds while providing a homepage where the ICO takes place. The second
step involves participants/investors delivering cryptocurrencies such as Bitcoin or Ether to a
designated address and they receive tokens in exchange for them, these coins can be viewed as
incorporating an option to participate in a subsequent ICO. For long duration ICO’s the prices of
tokens rise during the ICO period.

Trading of cryptocurrencies takes place 24 hours a day and every day of the year on one of
many electronic exchanges. Most exchanges take form of an open electronic limit order book,
but without centralized regulation, market limits or order size rules. A very low correlation is
found between cryptocurrency indexes (CRIX) and traditional financial assets. Features of
cryptocurrencies include the following: decentralized, flexible (e.g. transactions are not location
specific), transparent (every transaction is broadcasted to the entire network), fast (transactions
are broadcasted within few seconds), low transaction fee (no transaction fee is required to make
transfer, but owner can opt to pat extra fee to facilitate faster transaction).

Valuation of cryptocurrencies is different from traditional instrument. Unlike stocks and bonds
cryptocurrencies generate no cash flows, cryptocurrency tokens are are given to investors as
proof of future cash flow, making DCF valuation inapplicable. Ethically cryptocurrencies are
good as well as bad at both micro as well as macro levels. Their good thing at micro level is that
they reduce poverty through reduced transaction cost, while bad at micro level includes
facilitation of nefarious consumption. At the macro level the good part includes reduction of
hyperinflation of monetary policy and the bad part includes tax evasion.

The effect of cryptocurrencies on valuation of other assets can be examined through correlation
analysis. Empirical evidence suggests that a very low correlation exists between CRIX and other
traditional assets such as S&P 500, private equity, gold, GSCI index, bonds, oil, T-Note etc. All
correlations with traditional assets are less than 0.1, which indicates that cryptocurrencies are
negatively correlated with mainstream assets. The spillover tests based on vector autoregressive
framework also revealed that there is very limited connectedness between crypto markets and
traditional asset markets. However, although crypto markets are decoupled from other popular
financial asset markets, they are interconnected with other asset markets, which potentially
indicate that increase in cryptocurrency prices can be due to high speculative activities in
traditional asset markets and vice versa.
 Overall cryptocurrencies outperform traditional asset classes in terms of average daily return.
The annualized return for CRIX 30.24% which is very high in comparison to stock market (S&P
500) whose return equates to 0.12%. As per empirical study CRIX tends to have higher volatility
compared to S&P 500, with a daily maximum drawdown of -22.64% and skewness of -1.04. In
case of kurtosis the return distribution of cryptocurrencies deviates from normal distribution.
Comparing CRIX with traditional assets, we see that CRIX has the highest return and is the only
asset which lies in the efficient frontier. The performance sentiment between cryptocurrencies
and other traditional assets can be examined by adopting 3 measures used to compute risk
adjusted returns which include: daily Sharpe ratio, daily information ratio, and daily maximum
drawdown. Due to change in prices of traditional assets caused by speculation in the crypto
market, it can be said that cryptocurrencies do effect the valuation of other assets despite having
lower correlations. CRIX and cryptocurrencies serve as good options to diversify portfolio risk
furthermore efficient frontier, which elaborates the modern portfolio theory illustrates that
cryptocurrencies significantly expand the efficient frontier relative to traditional assets and may
also significantly impact the valuation of traditional assets despite negative association in trends.

Research suggests that cryptocurrencies in a market portfolio contain high levels of

idiosyncratic risks that are difficult to hedge against. Results also support the position that
cryptocurrency market is a new investment asset class; since they are interconnected with other
asset classes and due affect their valuation as well by having similar patterns of connectedness.
(Chuen et al.,2017)

Chuen, K., David, L. E. E., Guo, L., & Wang, Y. (2017). Cryptocurrency: A
new investment opportunity?.

Chicago