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In order to be considered successful a firm must produce returns greater than alternative investment

PDF Abstract Bitcoin was the first cryptocurrency to use blockchain and has been the market in order to be considered successful a firm must produce returns greater than alternative investment since the first bitcoin was mined in 2009. After the birth of Bitcoin with the genesis block, more than 1,000 altcoins and crypto-tokens have been created, with at least 919 trading actively on unregulated or registered exchanges. This entire class of cryptocurrencies and tokens has been classified by some tax authorities as having the same status as commodities.

If cryptocurrency is viewed in the same class as commodities, how different is it in terms of its risk and return structure? This article sets out to help readers understand cryptocurrencies and to explore their risk and return characteristics using a portfolio of cryptocurrency represented by the Cryptocurrency Index CRIX. Some questions are raised about the potential of cryptocurrencies as an investment class. Results show that the return correlations between cryptocurrencies and traditional assets are low and that adding CRIX returns to a traditional asset portfolio improves risk—return performance.

Although we should view the results with care, a new form of financing for cryptocurrency and blockchain start-ups is born. The disruption brought about by Bitcoin may be felt beyond payments through what is known as initial crypto-token offerings or initial token sales. The invention of Bitcoin 1 by Satoshi Nakamoto Nakamoto [2008] in 2008 spurred the creation of many new cryptocurrencies known as altcoins.

These altcoins use similar cryptographhy technology but employ different algorithmic designs. Many of these altcoins were invented for different purposes or to address the pain points of the Bitcoin network, such as the high usage of energy caused by its proof of work PoW consensus algorithm or the supply limit of 21 million coins, among others.

As the network effect weighs in, the prices of bitcoin and its variants have risen in tandem. These innovations and the perceived investment potential have led to rapid growth in the number of altcoins and the market size of cryptocurrency.

Many have argued that, despite their payment utility, bitcoin and cryptocurrencies have no intrinsic value and may be the perfect vehicle for forming a bubble. Even for those who believe that there is intrinsic value to cryptocurrencies, when their prices are rising, there will be doubts about prices running ahead of values. Technologists will argue that their value is higher than Linux and lower than the Internet—yet both are facilitators rather than an asset class. Finance traditionalists will argue that cryptocurrency is just another form of value transfer that raises funds globally using cryptography and creates little value beyond that.

Cryptocurrency is a subset of the class of digital currency Lee [2015]but it has become an important type of digital currency. Unlike other digital currencies that can be centrally issued, circulated within a community or geographical location, or tied to fiat currency or the organizations issuing them, cryptocurrency has very different characteristics.

The blockchain technology used by cryptocurrency, such as Bitcoin, is an open distributed ledger that records transactions. This solves the double-spending problem and does not require a trusted third party. Decentralization allows the blockchain technology to have increased capacity, better security, and faster settlement. Some of these features are at the top of the list of shortcomings of traditional financial systems.

  1. It is possible to spend the same digital coin more than once.
  2. First, the current sample period of CRIX is too short to fully explore the investment opportunity of cryptocurrencies. For example, the euro will go down and the dollar will go up.
  3. The value of gold is determined by the market 24 hours a day, with trade relying more on sentiment and less on supply and demand. Correlation Analysis Almost all correlations in Appendix D are less than 0.
  4. Some questions are raised about the potential of cryptocurrencies as an investment class.

As a result, blockchains and cryptocurrencies have become two of the most pressing topics in the financial industry. In this article, we focus on the diversification role of cryptocurrencies and explore the possibility that they may generate new investment opportunities based on historical data. We first evaluate the comovement between traditional asset classes and the cryptocurrency index CRIX by studying their correlation coefficients Chen et al. Results suggest a very low correlation between CRIX and traditional assets based on historical data.

This observation suggests that cryptocurrency as an asset class is a good diversifier in a traditional portfolio. We then employ a multivariate dynamic conditional correlation DCC model to examine dynamic comovements for robustness Engle [2002]. Consistent with our expectations, cryptocurrencies are considered a potentially better portfolio diversifier under the DCC setting. Next, we investigate whether the inclusion of cryptocurrencies in a traditional portfolio will lead to additional benefits in terms of risk-adjusted returns.

Our empirical results show that CRIX not only expands the efficient frontier of an initial portfolio consisting only of traditional assets, it also provides additional utility to investors, as evidenced by the mean—variance spanning test.

However, it seems that cryptocurrencies may not lead to a large improvement in the utility of a mean—variance investor. There are various explanations for this finding. First, the current sample period of CRIX is too short to fully explore the investment opportunity of cryptocurrencies.

Hence, it is important for investors to understand the return—risk structure of cryptocurrencies before making an investment commitment. In this article, we conjecture that the high volatility of cryptocurrency is driven mainly by investor sentiment, not by a change in fundamentals.

We do not argue that there are no fundamentals, but rather that there has not been any meaningful interpretation using traditional fundamental analysis. Either the old economy framework is not suitable for a new and complex technology such as cryptocurrency, or immeasurable fundamentals are proxied by sentiments. We then propose an investor sentiment measure based on the past average returns for the cryptocurrency market. Our measure of investor sentiment reveals a strong return reversal on the next trading day, suggesting rational investors explore the benefit of sentiment-induced mispricing.

To further explore the sentiment effect, we use the Fama—MacBeth regression Fama and MacBeth [1973] to examine the cross-sectional premium of investor sentiment by using the top 100 cryptocurrencies that are components of CRIX. As a result, we identify potential profits from using daily trading strategies based on investor sentiment. The strategy that buys low-sentiment and sells high-sentiment cryptocurrencies generates an annualized return of 8.

We also conduct two analyses to assess the robustness of our findings. Our sentiment strategy survives after assuming reasonable transaction costs from 1 to 10 bps per trade.

The result is not sensitive to the selection of formation period of investor sentiment. Overall, our results provide some evidence of cryptocurrencies being a potential candidate as a new investment vehicle. The rest of the article is organized as follows. We first introduce the background of the cryptocurrency market. The next section presents empirical results on the diversification role of cryptocurrencies, and the following section explains the sentiment impact on the cryptocurrency market with robustness checks.

The last section concludes. Prior to the creation of cryptocurrencies, there were many other types of digital currencies. The most common example is a digital currency created by an institution and transacted on a platform. Such currencies can be loyalty points created by companies or digital coins created by Internet-based platforms.

The institutions or legal entities control the creation, transaction, bookkeeping, and verification of the digital currencies. In other words, these platform-based digital currencies are centralized. A notable example is the loyalty points of e-commerce companies like Rakuten and iHerb, which function like cash on the platform. Q-coin, introduced by the Chinese social platform Tencent, can be bought using the Renminbi and can be used to buy services at Tencent.

World of Warcraft Gold is a game token that can only be earned through completing in-game activities and cannot be bought or exchanged into fiat currencies Halaburda [2016]. These centralized digital currencies are transacted within a specific platform and are designed to support the business of the issuing institutions.

It is difficult to use them as a substitute for fiat money because these centralized digital currencies are not legal tender. Therefore, decentralized digital currencies seem a potential replacement for fiat money as no central authority is needed to verify the transactions.

However, there are still many obstacles to overcome without the use of an intermediary or central authority. One main obstacle is the double-spending problem: It is possible to spend the same digital coin more than once. This problem has remained unsolved for a long time, discouraging the prevalence of decentralized coins.

To ensure every transaction is accurately reflected in the account balance for digital currencies to prevent double spending, there is a need for a trusted ledger without a central authority. In order to be considered successful a firm must produce returns greater than alternative investment first cryptocurrency, eCash, was a centralized system owned by DigiCash, Inc. Although it was phased out in the late 1990s, the cryptographic protocols it employed avoided double spending.

A blind signature was used to protect the privacy of users and served as a good inspiration for subsequent development. Shortly after the discovery of cryptography protocols, digital gold currency became popular, among which the most used was e-Gold. It was the first successful online micropayment system and led to many innovations, making transactions more accessible and more secure.

The global financial crisis in 2008, coupled with a lack of confidence in the financial system, provoked considerable interest in cryptocurrency. A ground-breaking white paper by Satoshi Nakamoto was circulated online in 2008.

In the paper, this pseudonymous person, or persons, introduced a digital currency that is now widely known as bitcoin. Bitcoin uses blockchain as the public ledger for all transactions and a scheme called PoW to avoid the need for a trusted authority or central server to timestamp transactions Nakamoto [2008]. Because in order to be considered successful a firm must produce returns greater than alternative investment is an open and distributed ledger that records all transactions in a verifiable and permanent way, it solves the double-spending problem.

These bitcoins can be transacted via software, apps, or various online platforms that provide wallets. Another way to obtain bitcoin is through mining. The Bitcoin system runs on a P2P network, and transactions happen directly between users with no intermediary.

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Bitcoin decentralizes the responsibilities of verifying the validity of transactions to the entire network. Transactions are recorded in the public ledger called blockchain and are verified by network nodes, which could be any individual using a computer system with Bitcoin software installed.

Once users have made a transfer, the transaction will be broadcast between users and confirmed by the network. Upon verification, it will be recorded in the blockchain, and then the transfer is completed.

This record-keeping process is referred to as mining, and people offering the computing power to do so are called miners. Bitcoins are created as an incentive for solving the cryptography puzzle using transaction data; thus, successful miners are rewarded with the newly created bitcoins, on top of transaction fees.

Each transaction contains inputs and outputs. An input has the reference to the output from the previous transaction, and the output of a transaction holds the receiving address and the corresponding amount Nirupama and Lee [2015].

In general, in a transaction, a certain number of bitcoins is sent from a bitcoin wallet to a specific address, if there is a sufficient bitcoin balance in the wallet from previous transactions. Transactions are not encrypted and can be viewed in the blockchain with corresponding bitcoin addresses, but the identity of the sender or receiver remains anonymous.

Typically, bitcoin wallets have a private key or seed that is used to sign transactions. This secured piece of data provides a mathematical proof that the coins in the transaction come from the owner of the wallet. With the private key and the signature, the account can only be accessed by the owner, and transactions cannot be altered by someone else.

The records are grouped and stored in blocks. Each block contains a timestamp and a link to a previous block so that the blocks are chained together, thus the name blockchain.

The blocks are mined in sequence, and once recorded, the data cannot be altered retroactively. A complete record of transactions can be found on the main chain.