Crypto Investors Receive Downside Risk Premiums

Victoria Dobrynskaya, Assistant Professor at the HSE Faculty of Economic Sciences, has analysed the price dynamics of 2,000 cryptocurrencies from 2014 to 2021 and investigated the association between downside risks and average returns in the cryptocurrency market. As it turns out, cryptocurrencies exhibiting a greater risk tend to yield higher average returns. The study has been published in International Review of Financial Analysis.

Cryptocurrencies have burst into our lives as new alternative investment assets offering huge potential returns alongside the risk of severe crashes. Between 2014 and 2021, the total capitalisation of the crypto market increased from $1 billion to $3 trillion, with the number of different cryptocurrencies traded exceeding 20,000. Returns on individual coins have ranged from as high as 20,000% to as low as -100% within a single week. These extraordinary return dynamics have attracted considerable attention from both the mass media and academia, though the unique characteristics of this market pose a challenge for its study.

Several earlier papers have cautioned against speculative bubbles and fraud in the cryptocurrency market. According to widespread opinion, the crypto market is characterised by peculiar return dynamics and crash risks to which no other assets are exposed.

There was a lack of understanding about the nature of those instruments and the pricing mechanisms at play in this market. Many people believed that cryptocurrencies were only used for money laundering and facilitating illicit transactions.

Victoria Dobrynskaya
Author of the paper, Assistant Professor, Faculty of Economic Sciences, HSE University

Other researchers were more optimistic and attempted to apply pricing models from conventional assets, such as the Capital Asset Pricing Model (CAPM), to cryptocurrencies, with modifications in order to accommodate the unique characteristics of the latter. However, early empirical studies indicate that cryptocurrency returns are generally unrelated to risk factors, which explain excess returns of equities, commodities, and conventional currencies. Furthermore, there is an ongoing debate as to whether cryptocurrencies can serve as effective tools for portfolio diversification and hedging or possess the properties of a 'safe haven'.

As the study claims, it is important to understand how various cryptocurrencies are affected by risks in both the cryptocurrency and equity markets and whether a higher sensitivity of individual cryptocurrencies to these risks is compensated by their elevated average returns. In other words, the question is how the general market risk and particularly the downside market risk is priced (or if it is priced at all) in the cryptocurrency market and what constitutes the risk premium in this market.

Dobrynskaya conducted a cross-sectional analysis to examine the risks of some 2,000 major cryptocurrencies with a capitalisation exceeding one million dollars, and separately for subsamples of larger cryptocurrencies with capitalisations surpassing 10 million and 100 million dollars, spanning the period from 2014 to 2021.

The author studied the cryptocurrency market crash risk factor, which measures systematic downside risk, and assessed the linear dependence of individual cryptocurrencies on this factor. The study reveals variations in crash sensitivity among individual cryptocurrencies; and incorporating this factor into the standard capital asset pricing model (CAPM) for cryptocurrencies substantially improves the model's explanatory power.

The researcher concludes that, in terms of downside risk, the cryptocurrency market operates on the same principles as conventional financial markets. The primary distinction between conventional and cryptocurrency markets lies in the fact that the latter offers significantly higher risk premiums.

By sorting cryptocurrencies based on their market crash sensitivity and constructing a portfolio with a long position for the most sensitive cryptocurrencies and a short position for the least sensitive ones, it is possible to attain consistently positive returns that compensate for the downside risk.

Victoria Dobrynskaya
Author of the paper, Assistant Professor, Faculty of Economic Sciences, HSE University

IQ

December 20, 2023