Abstract
The fundamental objective of portfolio diversification is to construct a portfolio of uncorrelated or mildly correlated assets so as to maximize the risk-adjusted returns on a portfolio. Portfolio Optimization is one of the techniques used by investment professionals to explore the potential of different assets in maximizing the risk-adjusted returns of the portfolio by adjusting the weight of each asset using simulations or constrained scenarios. A significant amount of research has already been conducted in the area of portfolio diversification that helps investors in devising their investment strategies and policies. Cryptocurrencies in general, and Bitcoin in particular, have aroused significant interest among investment professionals, policymakers, and regulators alike. Although much research has primarily focused on the legal and technological aspects of Bitcoin, the examination of other financial, diversification, hedge, and safe-haven aspects of Bitcoin has not progressed as far. This study explores the potential of Bitcoin as an alternative asset, and its potential in portfolio diversification, by using the portfolio optimization approach. The study employs the portfolio optimization approach under multiple constraining scenarios to evaluate the effectiveness of Bitcoin in portfolio diversification. A Monte-Carlo Simulation approach is then employed to evaluate the outcomes under each scenario by randomizing the outcomes of portfolio optimization. This study suggests that Bitcoin, due to its exotic nature, unwavering appeal, and unknown set of drivers, could at best act as a diversifier rather than a hedge or a safe-haven.
Highlights
IntroductionOne of the very disruptive and significant developments post-global financial crisis (GFC) has been the emergence of cryptocurrencies, Bitcoin in particular
The present study explores the potential of Bitcoin in portfolio diversification using a portfolio optimization approach as well as establishing the alternative asset characteristics of Bitcoin
The results suggest that Bitcoin has some potential to act as a diversifier because in almost all the portfolio optimization frameworks, the performance attributes of the portfolios with Bitcoin were considerably higher compared to portfolios without Bitcoin
Summary
One of the very disruptive and significant developments post-global financial crisis (GFC) has been the emergence of cryptocurrencies, Bitcoin in particular. As the GFC unfolded, investors discovered that they were less diversified than they originally thought they were and started looking for alternative investments that might be considered safe havens, hedges, or diversifiers. It was in this context that Bitcoin rose to prominence; by April 2018, Bitcoin (BTC) had a total market capitalization of more than USD 116 billion (Yi et al 2018), which rose to almost USD 700 billion by May 2021.1
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