Introduction
Since the COVID-19 pandemic, investors have increasingly turned to cryptocurrencies as alternative investments. Empirical studies highlight the spillover effects of financial shocks across economies, driving interest in assets like Bitcoin, which was initially perceived as uncorrelated with traditional markets. Despite their volatility, cryptocurrencies such as Ethereum, Binance Coin, and Cardano have gained traction for portfolio diversification.
This paper examines whether cryptocurrencies enhance portfolio performance by analyzing their risk-adjusted returns and correlations with major indices like the S&P 500 and FTSE 100. Contrary to popular belief, our findings suggest cryptocurrencies may increase risk without commensurate returns, challenging their role as effective hedges.
Data and Methodology
Sample Selection
We analyzed eight major cryptocurrencies (Bitcoin, Ethereum, Cardano, etc.) and four market indices from September 2014 to May 2022. Stablecoins were excluded due to their pegged nature. Data was sourced from Thomson Reuters Eikon.
Analytical Framework
Dynamic Conditional Correlation (DCC) Model:
- Measured time-varying correlations between cryptocurrencies and indices.
- Key equation:
[
\text{MKT\_Ret}_{i,t} = \alpha_{0,t} + \beta_1 \text{COIN\_Ret}_{i,t-1} + \beta_2 \text{MKT\_Ret}_{i,t-1} + \varepsilon_t
]
Portfolio Construction:
- Optimized weights using mean-variance analysis.
- Evaluated Sharpe ratios to assess risk-adjusted performance.
Key Findings
Volatility & Returns:
- Cryptocurrencies exhibited 38.73% avg. volatility (BTC) vs. 1.26% for the S&P 500.
- High skewness/kurtosis indicated non-normal distributions.
Correlation Analysis:
- BTC and S&P 500: Significant correlation (p = 0.083).
- ADA showed the strongest linkage (p = 0.088).
Portfolio Performance:
- Inclusion of crypto increased risk (e.g., Sharpe ratio for S&P 500 dropped from 0.92 to 0.86 with BTC).
- Only the FTSE 100 showed slight improvement.
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Discussion: Interest Rates and Market Downturns
Interest Rate Impact
- Cryptocurrencies moved inversely to rising 10-year Treasury rates (May 2021–May 2022).
Correlation coefficients:
- BTC: -0.438
- DOGE: -0.726
2022 Market Downturn
- Cryptos like Solana (-117% return) mirrored stock declines.
- Hedging benefits diminished during crises.
Out-of-Sample Testing (COVID-19 Period)
| Portfolio | Return (with BTC) | Sharpe Ratio |
|---|---|---|
| S&P 500 | 31.52% | 0.86 |
| FTSE 100 | 5.52% | 0.20 |
Conclusion: Cryptos boosted returns but not risk-adjusted performance.
FAQs
Q1: Do cryptocurrencies hedge against market downturns?
A: Our data shows they lost hedging properties during the 2022 downturn, with high correlation to indices.
Q2: Which crypto had the lowest volatility?
A: Ethereum (5.10% Std. Dev.) vs. Bitcoin’s 38.73%.
Q3: Is crypto suitable for conservative portfolios?
A: No—their high risk may destabilize low-risk strategies.
Conclusion
Cryptocurrencies do not consistently improve portfolio performance. While they offer high returns, their volatility and correlation risks outweigh benefits. Investors should weigh these factors carefully before allocation.
👉 Learn more about crypto risk management for informed decisions.
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