Hedging and Diversification Benefits of Cryptocurrencies: A study of a novel asset class

Abstract: The purpose of this study is to conduct an examination into the hedging capabilities and diversification benefits of cryptocurrencies with the aim to add to a very limited set of existing literature. The objective is to investigate whether or not the role of cryptocurrencies in financial markets pertain to hedging and improving risk-adjusted returns. As with every novel asset class, characterizing its attributes and role on the financial markets becomes a paramount academic question. Furthermore, the rapid adoption of blockchain technology and expansion of market capitalization since Bitcoin's inception in 2009, a proper understanding of cryptocurrencies on the financial markets is warranted. This study takes the perspective of two types of mean-variance optimizing investors, differing only in their extent of diversification. Three primary statistical tests are used to produce the empirical results: the spanning test, the specification error bound test, and the step-down test. The findings in this study suggest that there are statistically significant diversification benefits for a passive long-term investor. An additional observation is that these benefits show no sign of diminishing with increasing investor diversification. In contrast, on a year-by-year basis, the findings suggest that diversification benefits are less pronounced for both types of investors, potentially slightly favoring a less diversified investor. The findings also point to the significance of diversification benefits being poorly correlated with general market volatility. These results corroborate a pessimistic view of the hedging capabilities of cryptocurrencies in a recent history of research in this area known for its mixed results.