Cryptocurrencies, and most notably Bitcoin, are recognized as decentralized currencies. While some see Bitcoin (BTC) as a payment method of the future, others see it as a speculative asset class. No doubt, many have gained on the skyrocketing prices of BTC, but note that many have lost.
Despite the speculative activity connected with BTC, after all, it is a currency that is different from fiat currencies like the US Dollar or Euro. If you hold fiat currency, there is an opportunity to earn a risk-free rate. The idea of a risk-free rate is based on the assumption that the government would not default, which is usually a regular assumption amongst best economies.
The risk-free rate of Bitcoin
Is there any risk-free rate for such a volatile currency/asset class as Bitcoin? Certainly, the passive holding of Bitcoin does not provide any coupon or dividend; therefore, there is no visible interest rate connected to it. While there is no risk of default (there is a risk of getting the crypto wallet or exchange profile hacked), characteristics of such asset class would be far from the characteristics of government bonds.
A possible approach is to look at the Bitcoin as an asset class and find the risk-free rate in the regulated derivatives market (CME). The BTC is a decentralized currency that does not have any government bonds that could be considered as risk-free assets. However, if we have risk-free government bonds for fiat currencies, there are derivatives where the bonds are underlying assets. The price of the derivative is dependent on the price of the underlying asset, and assuming the no-arbitrage rule, the return must be the same. Therefore, we can extract the risk-free return from the futures market.
We can use this idea for BTC analysis.
As a result, let’s try to look at the difference between the front-month (first futures contract) and back-month future (third futures contract). To be more precise, we can try to extract a risk-free rate as follows:
It would be more natural to buy BTC for a spot price and hedge it by shorting the back-month futures, but with our data availability, we have opted for the approach with futures only. We might revisit this topic in the future also with BTC spot prices.
Therefore, instead of going long BTC spot, we go long the front-month contract and short the back-month contract. Consequently, we are hedged against any decline of the BTC price since we have locked the price of BTC.
Visit Quantpedia to read the full article:
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from Quantpedia and is being posted with permission from Quantpedia. The views expressed in this material are solely those of the author and/or Quantpedia and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.