What is Crypto? Does it Matter?

The run-up in the virtual currency “Bitcoin” and some other virtual currencies has created a lot of questions among investors. Beyond making a simple speculative (i.e., gambling) play on the currency, the question for smart investors is whether virtual currencies belong in a well-diversified, return-to-risk maximizing portfolio (a smart-beta portfolio).

The way to answer this question is to start by looking at other non-virtual currencies, like the Euro or the Yen. The risk-return properties of a currency are the same whether the currency is virtual or non-virtual. So, should a smart-beta portfolio hold currencies in general?

A smart-beta portfolio holds investments that provide high risk premia relative to the risks being taken. A risk premium for a security is simply the average amount of extra return that an investment provides to compensate an investor for holding the security and bearing the risk of losses on the holding. For example, it is widely believed that for the S&P 500 the risk premium is about 7%. It’s important to note that a risk premium can never be negative for traded securities; investors would not be willing to hold a security with a negative risk premium (why bother taking risk if your expected compensation for doing so is negative). So, the market price of that security would adjust downward until its risk premium was at least zero if not higher.

So, what is the risk premium for currencies? A simple way to think about this is to consider two investors. The first is a US investor and is holding Euros as an investment and will eventually sell the Euros for Dollars. The second investor is a German investor and is holding Dollars as an investment and will eventually sell the Dollars (for Euros). So what is the risk premium for each currency? To determine the risk premium we first need to figure out the risk factor that each investor faces. The risk that the US investor faces is the Dollar/Euro exchange rate. If the Euro the Dollar/Euro exchange rate increases, i.e., the Euro appreciates (the Dollar depreciates),  the US investor will make money. If the exchange rate decreases, the US investor will lose money. Similarly, the German investor’s risk is the Euro/Dollar exchange rate (the reciprocal of the Dollar/Euro exchange rate). If the Euro/Dollar exchange rate increases (the Dollar appreciates), the German investor will make money, and if the exchange rate decreases, the German investor will lose money. The key fact to notice is that each investor has a risk exposure that is exactly opposite of the other’s exposure. So, let’s suppose that the Dollar/Euro exchange rate has a risk premium of 5%. Then necessarily, the Euro/Dollar exchange rate must be the exact opposite, i.e., it must be -5%. However, we know from the discussion above that a risk premium can never be negative; otherwise, in this example, the German investor would not be willing to hold Dollars because the expected payoff for doing is -5%. So, the situation in this example could never occur. In fact, the risk premium for any exchange rate cannot be positive because it would necessarily imply the risk premium for the opposite (reciprocal) exchange rate is negative. Hence, we arrive at the conclusion that the risk premium for all currencies must be 0. This result holds for virtual currencies as well because the same arguments that we used above holds for any virtual currency and the Dollar.

Our objective is to maximize the long-run return per unit of risk taken (known as the Sharpe ratio in financial circles) in the portfolio. With a risk premium of 0, currencies are a drag on a Sharpe ratio-maximizing portfolio. Therefore, we do not take direct currency risk exposure in the portfolio. That doesn’t mean there is no currency exposure in the portfolio. The portfolio incurs (indirect) currency exposure through its holdings of multinational companies, which have operating revenues and profits in many currencies. While we could hedge this currency exposure to increase the Sharpe ratio of the portfolio, because these companies have exposures to multiple currencies their exposures naturally cancel out, leaving very little net currency exposure in the portfolio. The same principle applies to virtual currency exposure - we do not seek direct exposure to virtual currency exposure, but many companies utilize virtual currencies in their supply chains, and therefore, we end up with some net indirect exposure to virtual currencies.

Finally, another hot topic related to virtual currencies is blockchain technology. Basically, blockchain technology allows for any third-party company or individual to maintain a record of virtual currency transactions, rather than only specialized financial institutions doing it, as in the case of transactions utilizing Dollars. It is essentially record-keeping technology, and while it originated with virtual currencies, it is being utilized much more broadly. Because it is being broadly adapted by companies, a portfolio should have exposure to blockchain technology - both indirect as well as direct. We’ll have more to say about blockchain technology in a future commentary.