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What is the Bitcoin’s Risk-Free Interest Rate?

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Introduction

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.

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