LETTERS: Bitcoin is a digital currency that has attracted a lot of attention recently. Its price soared to a record high of US$57,128 on Feb 22, an increase of 96 per cent from the price recorded early this year.
As the world's first decentralised digital currency, Bitcoin's escalating prominence in the global financial system can no longer be ignored.
Despite being considered as an innovative payment tool that offers an alternative global monetary system, there are opinions that Bitcoin and other cryptocurrencies may be grouped as a new investment asset category.
Therefore, the interaction of Bitcoin and other investment assets, such as stocks, gold and bonds, offer investors options to diversify their portfolios to reduce their risk exposure.
As an investment asset, cryptocurrency-linked volatilities remain high compared with other financial assets, thus portraying higher risks and higher returns. For investors who are willing to bear the risks, the emerging cryptocurrency market is attractive as they provide opportunities to obtain good returns.
However, can investors reduce investment risks by incorporating Bitcoin into their portfolio? To answer the question of whether Bitcoin reduces an investment portfolio's risks, it is crucial to know whether the cryptocurrency moves in sync with other financial assets.
The co-movement between Bitcoin and other financial assets, such as stocks, can be examined by looking at the correlations between the two assets. By incorporating negatively correlated asset classes in portfolios, investors seek to diversify the risks of their portfolios.
Diversification is achieved when the losses in an asset are offset by gains in a negatively correlated asset. In a portfolio that consists of Bitcoin and stocks, the correlation among these asset classes explores the influence of the cryptocurrency's prices on the prices of stocks, thus offering new information to the investors.
Therefore, understanding the interaction between Bitcoin and stocks helps investors to make better investment decisions.
For example, knowing the long-term co-movement between Bitcoin and stocks helps investors identify diversification opportunities and build an effective hedging strategy for their portfolios.
On the other hand, information on the integration of Bitcoin and stocks offer valuable information to speculators. The rapid development of blockchain technology has facilitated the role of Bitcoin and other cryptocurrencies as investment assets in the financial mainstream.
Nonetheless, Bitcoin remains volatile. The movements of Bitcoin prices are linked to financial markets conditions and the risk tolerances of major investors against other financial assets.
The launch of the Bitcoin futures in December 2017 and Bitcoin options in January last year by the Chicago Mercantile Exchange Group have implications on portfolio diversifications. Such contracts have improved the efficiency of the Bitcoin market by providing a centralised marketplace for investors to hedge and trade the cryptocurrency.
A centralised marketplace may lead to higher integration between Bitcoin and other financial assets. An increase in the interdependence between Bitcoin and other financial assets may intensify the contagion effects from financial markets to the cryptocurrency's markets, as can be seen in terms of higher correlation of prices and returns.
Therefore, investors need to be aware of the changing functions of Bitcoin as a diversifier because the increased correlation between it and other financial assets have implications on portfolio diversifications.
TAY BEE HOONG
Senior lecturer, Faculty of Business and Management, Universiti Teknologi Mara, Johor
The views expressed in this article are the author's own and do not necessarily reflect those of the New Straits Times