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What determines cryptocurrency’s expected return?

by Dr Hui (Frank) Xu, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance

Coins of various cryptocurrencies.
Dr Hui (Frank) Xu
Dr Hui (Frank) Xu

Since the emergence of the cryptocurrencies, they have quickly become the focus of asset managers. Although many ongoing debates about cryptocurrencies still remain to be solved, e.g. whether their value can be justified, their relationship with the fiat money endorsed by the central banks, they do offer an alternative opportunity for the investors to diversify their portfolios. Yet before constructing a portfolio that subsumes cryptocurrencies, a question has yet to be answered: what is their risk and return profile and what are the determinants?

Since stocks markets are well developed and thoroughly studied, it is only intuitive to look at whether the factors that successfully account for stocks markets can also apply to the cryptocurrencies market. Although shares and cryptocurrencies are fundamentally different, they do share quite a number of similarities. Especially, some cryptocurrencies (digital tokens) represent the claim to the issuer. Eugene F. Fama and Kenneth R. French in 1992 found that size risk and value risk can account for the stock return in addition to the well-known beta, based on the evidence that value and small-cap stocks outperform market on a regular basis. Mark Carhart augmented the three-factor model by adding a momentum factor that describes the tendency for the stock price to continue rising if it is going up and to continue declining if it is going down.

A recent NBER Working Paper by Aleh Tsyvinski et al. tested the idea and showed that most of the powerful explanatory factors in the stock market, namely the beta, size and momentum, are also powerful to capture the cross-sectional expected returns of cryptocurrencies. Since the advent of cryptocurrencies, many have studied the expected returns and many explanatory factors have been suggested. Interestingly, they showed that all of the excess returns generated by the trading strategies that previous studies implied, can in fact be accounted for by the cryptocurrency three-factor model.

A further inquiry is whether there exists a “twin” value factor in the cryptocurrency market, why the size and momentum factors are so mysteriously powerful and whether they affect the cryptocurrency returns the same way as they do to the stock returns? One thing for sure is that as the cryptocurrency market continue to burgeon, all these questions will be answered eventually.