BITCOIN A CURRENCY, DIVERSIFIER OR HEDGE? - BITCOIN EN DIVERSIFIERARE, HEDGE ELLER VALUTA? - DIVA PORTAL

Emil Kirk Nordén & Karl-Fredrik Söderberg

Bitcoin a Currency, Diversifier or
 Hedge?
Bitcoin en Diversifierare, Hedge eller Valuta?

 Nationalekonomi

 Examensarbete Civilekonomiprogrammet

 Term: Spring 2021
 Supervisor: Karl-Markus Modén

Acknowledgements

We want to thank our supervisor Karl-Markus Modén for contributing with help and input
that made this paper possible.

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Abstract

Bitcoin is a cryptocurrency that has been on the market since 2009 and is the largest
cryptocurrency with regard to market cap. The place Bitcoin should have on the market is not
however clear. There are those who think it should be considered as an asset and those who
consider it to be a currency.

This study is aiming to determine if Bitcoin could work as a currency, diversifier or hedge. To
determine if Bitcoin is able to work as a diversifier or hedge, we are going to assess three
different tests. The tests that are going to be used are the Beta test, Pearson correlation test
and Sharpe ratio test. To be able to determine if Bitcoin could work as a currency the usage of
monetary theory and earlier studies will be used.

The result from this study suggests that Bitcoin should be classified as a speculative asset.
This study gives support that Bitcoin would work as a diversifier in a portfolio. It does not
give any support that Bitcoin could work as a hedge. Bitcoin is generating a higher risk
adjusted return in a portfolio than gold or silver does across the chosen time period. Bitcoin
does not show the properties that it will need to have for it to be introduced in the monetary
system. Bitcoin can therefore not be considered a currency in today’s economy.

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Sammanfattning

Bitcoin är en kryptovaluta som har funnits på marknaden sedan 2009 och är den största
kryptovalutan med hänsyn till marknadsvärderingen. Platsen som Bitcoin borde ha på
marknaden är fortsatt oklar. Det finns dem som tycker att de borde ses på som en tillgång och
de som ser det som en valuta.

Den här studiens syfte är att fastställa just om Bitcoin skulle fungera som en diversifiering,
hedge eller en valuta. För att kolla om Bitcoin fungerar som en diversifiering eller hedge
kommer tre test att utföras. Testen som använts är Beta test, Pearson korrelations test och
Sharpe ratio test. För att kolla om Bitcoin skulle fungera som en valuta kommer monetär teori
tillsammans med tidigare studier att användas.

Resultatet från studien indikerar mot att Bitcoin borde klassificeras som en tillgång. Studien
ger stöd till att Bitcoin skulle kunna fungera som en diversifiering i en portfölj. Studien ger
inget stöd till att Bitcoin skulle kunna fungera som en hedge. Bitcoin genererar en högre
riskjusterad avkastning i en portfölj än jämförelsetillgångarna guld och silver under den
utvalda tidsperioden. Bitcoin uppvisar inte de egenskaperna som de skulle behöva för att bli
introducerad i det monetära systemet. Bitcoin kan således inte anses vara en valuta i dagens
ekonomi.

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Table of Contents
1.0 Introduction ....................................................................................................................................... 1
 1.2 Purpose .......................................................................................................................................... 2
 1.3 Method .......................................................................................................................................... 2
 1.4 Delimitations ................................................................................................................................. 2
 1.5 Disposition..................................................................................................................................... 3
2. History of money ................................................................................................................................. 4
 2.1 Barter: the first transactions .......................................................................................................... 4
 2.1.2 The Cowrie ............................................................................................................................. 5
 2.1.3 The first metal money............................................................................................................. 5
 2.1.4 Emergence of coins ................................................................................................................ 6
 2.1.5 The first banknote ................................................................................................................... 6
 2.1.6 First privately issued banknotes in Europe ............................................................................. 7
 2.1.7 Abandoning the gold standard ................................................................................................ 8
 2.1.8 Fiat currency ........................................................................................................................... 8
 2.2 Competition among currencies ...................................................................................................... 9
3. Cryptocurrencies & blockchain ......................................................................................................... 10
 3.1 Transaction Process ..................................................................................................................... 11
 3.2 Decentralization in the Blockchain: ............................................................................................ 11
 3.3 Transparency in the Blockchain: ................................................................................................. 12
 3.4 Security of Blockchain: ............................................................................................................... 12
 3.5 Fiat currencies and cryptocurrencies ........................................................................................... 13
 3.6 Mining Bitcoin and other cryptocurrencies ................................................................................. 13
 3.7 Blockchains advantages and disadvantages ................................................................................ 13
4. Financial theory ................................................................................................................................. 14
 4.1 Hedging ....................................................................................................................................... 14
 4.2 Strategy in hedging...................................................................................................................... 15
 4.3 Diversification ............................................................................................................................. 15
 4.4 Beta as a measurement in investing............................................................................................. 16
 4.4.1 Hedging using beta ............................................................................................................... 17
 4.5 Sharpe’s ratio............................................................................................................................... 17
5. Data ................................................................................................................................................... 18
 5.1 Description of the data ................................................................................................................ 18
 5.2 Pearson correlation ...................................................................................................................... 18

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5.3 Correlation test on data................................................................................................................ 19
 5.4 Sharpe’s ratio............................................................................................................................... 22
 5.5 Beta test ....................................................................................................................................... 25
6. Earlier Studies ................................................................................................................................... 27
 6.1 Microeconomics of Cryptocurrencies ......................................................................................... 27
 6.1.1 Dishonest miners .................................................................................................................. 27
 6.1.2 Transaction fees for Bitcoin ................................................................................................. 27
 6.1.3 Could Bitcoin Become A “Digital” Gold ............................................................................. 28
 6.2 Recent data on use activity: where are we today ......................................................................... 28
 6.3 Can Bitcoin Replace Gold in an Investment Portfolio? .............................................................. 29
 6.4 The inefficiency of Bitcoin.......................................................................................................... 30
 6.5 On the Evolution of Cryptocurrency Market Efficiency ............................................................. 30
 6.6 Regulation spillovers across cryptocurrency markets ................................................................. 30
 6.7 Is Bitcoin a real currency? An economic appraisal ..................................................................... 31
 6.8 Bitcoin - Asset or Currency? Revealing Users' Hidden Intentions ............................................. 31
 6.9 Can Bitcoin Become a Major Currency?..................................................................................... 32
 6.10 Impact of Bitcoin as a World Currency ..................................................................................... 33
 6.11 Can currency competition work?............................................................................................... 34
7. Analysis ............................................................................................................................................. 35
 7.1 Pearson correlation ...................................................................................................................... 35
 7.2 Sharpe’s ratio test ........................................................................................................................ 35
 7.3 The Beta test ................................................................................................................................ 36
 7.4 Discussion of the tests ................................................................................................................. 36
 7.5 Analysis & Discussion of Bitcoin as a currency ......................................................................... 37
8. Conclusions ....................................................................................................................................... 40
 8.1 Is Bitcoin suitable as a hedge or diversifier................................................................................. 40
 8.2 Is Bitcoin suitable as currency ..................................................................................................... 41
9. Tips on further research ..................................................................................................................... 42
References ............................................................................................................................................. 42
Appendix ............................................................................................................................................... 46
 Table A.1 ........................................................................................................................................... 46
 Table A.2 ........................................................................................................................................... 47
 Table A.3 ........................................................................................................................................... 48
 Table A.4 ........................................................................................................................................... 49
 Table A.5 ........................................................................................................................................... 50

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Table A.6 ........................................................................................................................................... 51
Table A.7 ........................................................................................................................................... 52
Table A.7 ........................................................................................................................................... 53
Table A.8 ........................................................................................................................................... 54
Table A.9 ........................................................................................................................................... 55
Table A.10 ......................................................................................................................................... 56
Table A.11 ......................................................................................................................................... 57
Table A.12 ......................................................................................................................................... 58
Table A.13 ......................................................................................................................................... 59
Table A.14 ......................................................................................................................................... 60
Table A.15 ......................................................................................................................................... 61
Table A.16 ......................................................................................................................................... 62
Table A.17 ......................................................................................................................................... 63

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1.0 Introduction
In 2008 the person or persons with the alter alias Satoshi Nakamoto published a paper on the
newly opened site Bitcoin.org called “Bitcoin: A Peer-to-Peer Electronic Cash System”
(Nakamoto, 2008). In the paper Nakamoto (2008) outlines the framework that would become
the first modern cryptocurrency, namely Bitcoin. The idea of the system was to create a
decentralized currency that would not be tied to any tangible asset or country's economics.
Because Bitcoin is not pegged to any other valuable asset its value is dependent on the
security of the transactions and the believed value of the consumers. Since Bitcoin is a digital
asset, it is not restricted by countries borders and can have low transaction fees. Bitcoin is not
backed by any government or commodity meaning that it has no fundamental value. Bitcoin
is completely valued by the market. These characteristics made Bitcoin an enticing new
medium of exchange for many early adopters. For a currency to be able to act as a medium of
exchange there will have to be companies that accept it as a means of payment. In today’s
climate there are very few retailers that accept Bitcoin as payment and thus it cannot be used
as a means of exchange.

In recent years, the value of Bitcoin has skyrocketed from an early peak in December 2018 at
around 17 000 USD to around 3 000 USD in January 2019 and to around 64 000 USD in
April 2021. The extreme increase in value in 2017 made it a great story for the media. The
media started to report on Bitcoin and about the so-called Bitcoin millionaires. Due to the
immense media coverage more and more investors started to flock to the cryptocurrency with
the thought that it was a guaranteed investment. In late December 2017, the price fell, and
people experienced the volatility that is connected to cryptocurrencies.

Now there is a new boom of interest in Bitcoin. The new boom is mainly led by industrial
investors like Tesla and Microstrategies that have allocated large amounts of funds in the
cryptocurrency. The industrial investors have driven up the interest as well as the price to far
exceed the earlier peak in the end of 2017. Private investors and media have not forgotten the
events that followed the earlier boom. A lot of investors and media discuss whether it is a
bubble that is about to burst or an asset for the future.

The question of if Bitcoin and cryptocurrencies is an asset for the future has been investigated
immensely by economists but the question of where its place in the market would be is
something that have not been given the same amount of attention. Urquhart & Zhang (2019)

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tried to answer if Bitcoin can be considered as a hedge or a safe haven for currencies. Other
researchers, such as Halaburda, Haeringer, Gandal & Gans (2020), discuss the problems with
Bitcoin. One of the most frequent problems that is brought up is the criminal use of
cryptocurrency. There is a large difference between the figures reported as illicit use of
cryptocurrencies. Chainalysys (2021) estimates that 0.34% of all transactions with
cryptocurrencies is for illegal activities and Foley et. al (2019) estimates that 46% of all
transactions with Bitcoin is for illegal purposes.

This paper will focus on Bitcoin's place in the market. Until recent years Bitcoin has been
seen as an asset where people invest to make some quick returns and therefore it is a volatile
asset with low potential. Now there has been an inflow of industrial investors that allocate
large amounts of funds in Bitcoin as a more publicly accepted asset. The question is however
what are the investors investing in?

1.2 Purpose

The purpose in this paper is to determine if Bitcoin could work as a currency, diversifier or
hedge.

1.3 Method

We are going to fulfil the purpose of this paper through a quantitative study with secondary
data and with monetary theory. The data is gathered from Yahoo finance and Macrobond. The
tests that are going to be used to see if Bitcoin could act as a diversifier or hedge are the Beta
test, Pearson correlation test and Sharpe ratio test. To be able to determine if Bitcoin could
work as a currency the usage of monetary theory and earlier studies will be used.

1.4 Delimitations

In the paper we will limit our investigation to the largest cryptocurrency Bitcoin. The
currency that we will use secondary data from are British Pound Sterling (GBP), Euro (EUR),
Swiss Francs (CHF), Australian Dollar (AUD) and Japanese Yen (JPY). All of the currencies
are measured in relation to the US Dollar. The indexes that we will use in the test are S&P
500 (S&P), Dow Jones Index (DJI), Nasdaq 100 (NDX), Deutscher Aktienindex (DAX),
Hang Seng Index (HSI) and Nikkei 225 (N225). In the test we limit the data from 2017-01-01
to 2021-02-28. The data tested will be weekly closing prices meaning we will use a

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population of 217 data points. The comptonizations we will use to test against Bitcoin is gold
and silver. The value of Bitcoin, gold and silver is expressed in US dollars.

1.5 Disposition

The paper will be divided into these chapters:

Chapter 2 – History of Money

This chapter will begin with how the history of money first came to be, from its early form
inform of barter to how we trade today to how money is used today. In this chapter the
competition among currencies is also touched on.

Chapter 3 – Cryptocurrencies & Blockchain

This chapter will begin to introduce the reader to what a cryptocurrency is, how it works, how
the Blockchain system is built and ending with some advantages and disadvantages with the
Blockchain system.

Chapter 4 – Financial Theory

This chapter will begin to introduce the reader to what hedging is followed up by what
diversification is and both of their benefits in the investment world. Then the Beta test will be
touched on followed up by the theory behind the Sharpe ratio test.

Chapter 5 – Data

This chapter will begin with a description of the data that has been used followed up by a
brief introduction to what the Pearson Correlation test is, then the tests that have been
produced in the paper will be described and presented.

Chapter 6 – Earlier studies

This chapter will have some earlier studies presented and summed up which will later be
referenced in the analysis, discussion & conclusion chapters.

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Chapter 7 – Analysis & Discussion

This chapter will start by analysing the tests and giving interpretations of the results for the
tests followed up by a summary of all the tests and a comparison to previews studies.

Chapter 8 – Conclusion

This chapter will briefly summarize the results of the tests and discussion and reiterate the
paper’s purpose.

Chapter 9 – Tips on Further research

Some suggestions on future studies will be presented in this chapter.

2. History of money

2.1 Barter: the first transactions
Before the concept of currencies as a means of exchange the transactions in an economy were
made with barter (Davis 2002). In nature you can see a symbiotic relationship between
animals, insects and plants where they exchange services. An example of this is the
pollination of flowers where bees get nutrition at the same time, they spread the seeds of the
flower. The history of barter can thus be as old as man itself and the thing that has changed is
what item you use in the barter.

The problem with barter is the so-called coincidence of wants (Davis 2002). This scenario
describes the coincidence that in a trade, both parties will have to have a need or a want for
the other party's product. If there isn’t a coincidence of wants, there will not occur a trade
between the two parties due to the unavailability of the item they need or want. This problem
needed more complex trade relationships where you introduce several more parties in the
trade to be able to acquire the item you need. This process quickly becomes unmanageable
due to the logistical problem with having such a complex trade chain.

This early form of bartering soon evolved to a point where if you could not trade your item
for the item that you need you would instead trade it with an item highly sought after (Davis
2002). This trade was a store of value of the item you had produced. The highly sought-after
item would then later be traded for the item that you needed. The item that you traded could
for example be a high value dense item that easily could be transported. This item can then be

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brought to the next village and seek a trade there. It could also be an item that is easily stored
that you could use to try your luck another day. The more sought-after item that you were able
to trade your item into the more choices you would have for the next trade.

The straight barter evolved into a mix of barter and primitive currencies (Davis 2002). The
highly sought-after item described above evolved into a generally accepted medium of
exchange. This evolution occurred because it was commonly known that you can use the item
to exchange the item for the one you need. This was the first primitive currency.

2.1.2 The Cowrie

This evolution of money continued, and they arrived at the cowrie as a medium of exchange
(Davis 2002). The cowrie was mostly found in the Maldive Islands and from there it was
distributed around the shores of Oceania, Africa and the middle and far east. The cowrie shell
was small, durable, easy to transport, easy to count as well as not easy to counterfeit. These
properties of the cowrie shell made it a perfect medium of exchange. The cowrie proved to be
such a great medium of exchange there has been instances even today where it is being used
as money.

2.1.3 The first metal money

When the stone age ended and the metalworking began to blossom, we saw a change in the
coinage as well. At the end of the stone age the Chinese started to manufacture both bronze
and copper cowries (Davis 2002). The metals were so precious because its superiority over
stone that metal tools began to be used as a medium of exchange. The drawback of using
these metal tools is their size. They were hard to transport as well as hard to store. Later the
tools were reduced in size to be able to be more transportable and more storable. This
reduction in size led to the tools losing its purpose as tools and were more commonly used as
a means of exchange. The tools as a means of exchange were used for a long time in parts of
the world and there are sources stating that Julius Caesar castigated the Britons because they
used this form of means of exchange. These tools then transformed into more conventional
forms of coinage due to the need for easy storing as well as they are easier to count.

One of the pioneers in the coinage was the Chinese (Davis 2002). The Chinese started with
metallic currency as early as the end of the stone age with the bronze and copper cowries as
discussed above. The evolution of the coinage for the Chinese was roughly the one we saw in

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western societies with one exception namely that the coins were cast in base metal instead of
more valuable metal. This led to the coins not being value dense and therefore you would
need a large quantity to be able to conduct business. The solution the Chinese had for this is
that they made a hole in the middle of the coin so that you could place them on a rod or a
string. This made counting the currency simpler because you could just measure the string or
rod to see how much currency was on it. This was the first form of currency with different
denominations.

2.1.4 Emergence of coins

In the classical and Hellenistic age there was a large evolution in currencies and coinage
(Davis 2002). The Greeks used primarily silver which was mined through the mines located
in Laurion near Athens and in Macedonia. Gold was not seen as of any great importance and
therefore they preferred silver which they had access to in abundance. East of Ionia the gold
was instead preferred as a means of exchange. The Persians and Lydians, which were the first
people to mint coins with portraits on them, saw silver as a subsidiary to gold. The choice of
which metal to use was mostly depending on the availability of raw material.

These types of coins were later adopted by the Roman empire which used gold aureus, silver
denarii, silver sestertii and bronze asses (Davis 2002). The exchange rate between these was
fixed and it ranged from the least valuable one, which was the bronze asses, to the most
valuable one, which was the gold aureus. The Roman currency system spread throughout the
world due to the conquering of other nations and partly by trade.

2.1.5 The first banknote

When the trade system evolved the transactions got larger and larger (Szczepanski 2019).
This created a problem for the traders, namely the large amount of metal coins that needed to
be transported to the seller. The coins were heavy as well as expensive to store because you
needed security, such as vaults or guards, to protect your wealth. In the Tang dynasty in China
traders started to leave their coins with a trustworthy agent. This agent then wrote a receipt to
the trader that could be used to collect the coins. The receipt could then be transferred to the
seller as payment for the goods or services. The seller can then go to the agent and collect the
deposited coinage. The traders' idea spread all the way to the governing body and in the

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beginning Song dynasty the government licensed shops where people could deposit their
coins. This led to the first government issued banknote, the jiaozi.

2.1.6 First privately issued banknotes in Europe

Europeans had the same problem as the Chinese where when the trades got larger the number
of coins needed to be transported and stored got larger (Davis 2002). The Italian city states
which were the economic powerhouse of medieval Europe read about the exploits of Marco
Polo and adopted the monetary system in China. The banks in the trader’s city would issue a
receipt, that was often backed by a famous wealthy family, to the trader for the deposited
currency. The trader would then travel to the location of the trade and pay with the receipt, the
seller would then travel to his local bank to retrieve the payment and the local bank would
then demand the payment from the trader’s bank.

The problem with a governmentally backed currency is that the government had access to the
value behind it (Davis 2002). In those times there were a lot of expensive war campaigns that
the government could use this for. The solution for this was found by the English in the mid-
17th century where the citizens would deposit their wealth at a goldsmith. The goldsmith
already had vaults to keep their wares and raw material safe. The traders then received their
receipt that could be used to collect the currency. The goldsmiths realized that the that the
new business was more profitable than goldsmithing and started to shift their operation
towards it.

Each private bank had their own type of banknote (receipt) that they issued (Davis 2002). The
receipt could be exchanged at their bank and at other branches of the bank (if there were any).
This led to the different receipt being of different value. For example, if you are selling an
item and you have two potential buyers. One of the buyers has a banknote issued at a bank in
your city and the other one has a banknote of the same amount issued in a bank in a city 30
kilometres away you would value the one banknote from the same city higher. This is because
if you are going to cash this banknote into the correspondent currency it would take less time
and effort. This example is magnified when banks have several branches where you can cash
the banknote. The banks with several branches would be valued higher than the ones with
only a single or a few branches due to the increased amount of flexibility.

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2.1.7 Abandoning the gold standard

It is only in recent times that currency has shifted into more of a concept of exchange instead
of an actual value attached to it (Bordo n. d.). For most of our history the currency was
pegged to some other form of asset where gold being the most known one. The gold standard
was a system where you always had the possibility to exchange the currency to the
corresponding value in gold. Since the currency was pegged to gold the money supply could
not outgrow the gold supply. There was not a possibility to use fiscal stimulus such as an
increase in money supply to stimulate the economy.

The gold standard was suspended in the United States and many European countries in the
first world war (Bordo n. d.). This happened due to the need to increase military spending.
The increase in military spending required an increase in the money supply which was larger
than the availability of gold in these countries. After the war, most countries returned to the
gold standard. In the 1930s the great depression struck the world. The great depression led to
unemployment to largely increase and the currencies to deflate and economies were in dire
need of stimulus. Due to the gold standard the governments could not exercise monetary
stimulus and therefore led to most countries abandoning the gold standard.

The US dollar was stilled pegged to gold but the possibility of a private person to exchange
their dollar for gold was removed (Amadeo 2020). Most of the world's gold was held by the
United States and this led to economies pegging their currency to the USD instead of gold. As
the markets became more global and there was a large outflow of USD from the United States
the government realized that it was not possible to keep the gold standard. In 1976 the U.S.
government officially disconnected the dollar from gold.

2.1.8 Fiat currency

Fiat currency is a currency that is not backed by a physical commodity instead it's backed by
the government that issued it (Mankiw 2012). The value of the fiat currency is related to the
relationship between supply and demand and the stability of the issuing government.
examples of fiat currencies in the world are the U.S. dollar, the euro and British pound
sterling among other major global paper currencies.

Fiat currencies give central banks better control over a country's economy since they can
control how much money is printed, which can develop some specific risks (Mankiw 2012). If
a government decides to print too much money it will result in hyperinflation which is

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resulting in a useless currency. This is occurring since people will lose faith in a nation’s
currency, which leads to a currency that does not hold any value.

2.2 Competition among currencies

A Currency’s main role is to act as a store of value, unit of account and medium of exchange.
When an agent in a market sells a good to another agent the other agent hands over the
correspondent value in currency to the selling agent. The currency that has just shifted hands
is the store of value for the product that the selling agent has sold. The selling agent can then
use the currency to purchase another item that has the same correspondent value as the item
the agent has sold. This scenario explains how the currency is a medium of exchange, unit of
account and store of value. The question is however which form of currency is the best
medium of exchange, unit of account and store of value. In the section 2.1 (“History of
money”) we can see that, throughout time, currencies that have superior properties
outcompete the currencies that do not have these properties. This is the nature of competition
among currencies.

The question here is how does this competition work in today's economic climate. The central
banks are the only ones able to print money, with a few exceptions, and therefore are in full
control of the competition. Hayek (1976) argued that there should be an unbundling of money
to make competition a possibility. He believed that currencies mainly would compete as a
store of value. The medium of exchange must be a commonly accepted means of exchange to
enable further specialization. If there were competition in the medium of exchange, we would
have the problem with coincidence of wants again. For you to be able to purchase a good or
service the selling agent would have to need the currency that you are offering as payment.

Brunnermeier et. al. (2019) argues that there are two forms of competition among currencies.
Technology has made it possible to overcome many competition barriers which earlier had
not been possible. Brunnermeier et. al. (2019) also argue that digitalization has created a
whole different set of problems for competition among currencies. There is a distinction
between two types of competition which is full competition or reduced competition.

 1. Full Competition

 This type of competition is the one preferred by Hayek. Under full competition the
 currencies compete in all properties of money including as a unit of account. The
 currencies will have different price systems and different inflation rates. Competition

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is not only internationally, which is the case now, but also domestically, given that
 private entities are allowed to print their own currency. The private entities try to keep
 their money supply at an optimum level due to the competition of more stable and
 well-established currencies.

 2. Reduced competition

 Under reduced competition the currencies will only compete as a medium of
 exchange. The reduced competition is already implemented in several countries. There
 are electronic monetary instruments that act as medium of exchange. An example of
 this is when you get a token from a website when using the websites payment method
 that can later be used in future transactions.

3. Cryptocurrencies & blockchain
Broadly defined, a cryptocurrency is virtual or digital money that takes the form of a token or
a “coin” that exists on a decentralized and distributed ledger. The majority of cryptocurrencies
remain entirely intangible, but some have moved into the physical world in the form of credit
cards among other things. The “crypto” term in cryptocurrencies refers to a complicated
cryptography which allows the processing and creation of the digital currencies, this
cryptography allows the transaction to be in a decentralized system. Cryptocurrencies overall
are designed to be free from government manipulation and control. As the cryptocurrency has
grown more popular the fundamental aspect of cryptocurrencies has been more critiqued.
(Milutinović 2018)

Blockchain is a form of database which differs from a typical one. The biggest change is the
way of storing information, in the blockchain database the information is stored in blocks that
then are chained together. As new data comes into the system it is entered into a new fresh
block. When the new block has been filled with data it’s chained back with the previous
block, which chains the data together in chronological order. This type of system can be used
with various types of information, but the most common use of this database so far has been
as a ledger for transactions. (Nakamoto 2008)

If we take Bitcoin as an example, the blockchain database is used to decentralize the
information stored so that no person or group has control, but all users as a whole can retain
control of the system together. The decentralization of blockchains makes the entered data

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irreversible, which means that transactions are permanently recorded, and everyone can
observe it (Filippi 2016).

The biggest difference between a database and a blockchain is the storage structure.
Blockchain is gathering information together in groups (blocks) that stores the information.
The Blocks have a limited storage capacity, when they become full, they are chained onto the
previously filled block, which forms a chain of data this is known as “blockchain”.
This tells us that all blockchains are databases but not all databases are blockchains. In the
blockchain each block in the chain is given an exact timestamp when it is added into the chain
and grows into a part in the timeline. (Nakamoto 2008)

3.1 Transaction Process
A new transaction is entering the system, the transaction is later transmitted to a network of
nodes scattered across the globe. After that the nodes in the network solve the equations to
confirm that the transaction is valid. Then the transaction is clustered into a block. These
blocks are later chained together into the blockchain which creates a long history of all
transactions that are permanent, after that the transaction is complete. (Nakamoto 2008)

3.2 Decentralization in the Blockchain:
To easier understand the blockchain system we can look at how Bitcoin has implemented the
system. The blockchain for the Bitcoin is easily said just a database that stores every
transaction ever made by Bitcoin. One of the differences from an ordinary database is that the
computers used for Bitcoin is not under one roof, instead each computer or group of
computers is operated by a unique individual or group of individuals that could be in different
geographic locations. The computers that are being used in the Bitcoin network are called
nodes. Each node has registered the data that has been stored on the blockchain since its start.
In Bitcoins case the data is the entire history of all transactions made in Bitcoin. If one node
should put in the wrong data into the system, it uses the thousands of other nodes as a
reference point to correct the error it made. In doing so, no node in the network can alter
information within the network. Every transaction in the Blockchain is thereby irreversible.
If Bitcoins transaction history should be tampered with, all other nodes in the network would
cross reference each other and would easily tell where the node with the incorrect information
is. For Bitcoin this solution helps with transparency in the transaction history, but blockchain
can be used for much more variety like information in legal contracts, state identification and

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company’s product inventory. This system is ensuring that the changes made to the system or
information stored in the system will only be changed if it’s in the best interest of the majority
of the system. (Nakamoto 2008)

3.3 Transparency in the Blockchain:
Since Bitcoin’s Blockchain has a decentralized nature, all transactions can be transparently
viewed by either having a personal node or by using blockchain explorers that allow anyone
to see transactions occurring live. This allows tracking of Bitcoin being very easy and
everyone can track where a Bitcoin goes. (Nakamoto 2008)

3.4 Security of Blockchain:
The technology that blockchain possesses is granting security and trust in many different
ways. As mentioned earlier Blockchain stores information linearly and in chronological order.
In other words, the information is always attached to the “end” of the blockchain. After a
block has been added to the end of blockchain, it is truly difficult to go back and alter the
contents of the block, but if the majority reached a consensus to alter the contents it is
possible to do so. This is possible due to the blocks containing its own hashes, along with the
hash of the block before it, as well as the timestamp. Hash codes come from a math function
that basically turns digital information into a series of numbers and letters. If that information
is to be edited in any way, then the hash code changes as well.
The importance of this security is because let’s say a hacker would want to steal a Bitcoin
from someone and thereby trying to alter the blockchain. If they would alter their own single
copy of the hash, it would no longer line up with everyone else’s copy. When everyone else
cross references their copies against each-other, they would expose this altered hash copy and
then the hacker’s version of the chain would be cast away as illegitimate. (Nakamoto 2008)

To be able to succeed with such a hack the hacker would need to simultaneously control and
alter more than half of the copies of the blockchain so that their new copy becomes the
majority copy and thus, the agreed-upon chain. This attack will work as a Poisson distribution
and be harder to control the more transactions are added to the blocks. Blockchain is built this
way so that taking part in the network is far more economically encouraging than attacking
it according to (Nakamoto 2008).

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3.5 Fiat currencies and cryptocurrencies

An ordinary fiat currency like the U.S. dollar is controlled by a country's central bank. Under
this central authority system, a user’s data and currency is under the government or banks
control. If the authority system should be hacked, then the client’s private information is at
risk. If the user’s bank collapses or they live in a country with an unstable government, the
value of their currency may be at risk. These risks are one of the biggest concerns about fiat
currencies according to Chen (2019). The risks that Chen (2019) presents is two of the biggest
advantages with the cryptocurrencies and its blockchain system. Since the blockchain is
developed and operated without any need to have central authority, which reduces risk and
eliminates processing and transaction fees according to Bunjaku et al. (2017).

3.6 Mining Bitcoin and other cryptocurrencies

Mining Bitcoin or other cryptocurrencies is in short, the process of which new coins is
making its entrance to the world. This process is also necessary to both develop and protect
the blockchain. To make this mining process possible the nodes (users’ computers) in the
network has to be advanced to be able to solve complicated computational math problems to
be able to further extend the blockchain according to (Zhang et al. 2019).

People whose mining Bitcoin receive the currency as a reward by completing the “blocks” in
the hashes by verifying transactions which is then added to the blockchain. The rewards are
determined by how fast a miner’s computer is solving the complex hashing puzzle and a
faster solving speed is determined by the total mining power a miner has on the network
according to (Zhang et al. 2019).

Miners are rewarded for being the auditors of the blockchain for cryptocurrencies since they
are verifying the legitimacy of the Bitcoin transactions. Which is meant to keep the users
honest and prevent the so called “double-spending problem” (this is a scenario where a
Bitcoin is illicitly spent twice) according to (Zhang et al. 2019)

3.7 Blockchains advantages and disadvantages
Advantages:
Bunjaku et al. (2017) presents some compelling advantages for the Blockchain system, one is
the improved accuracy in the verification process since human involvement is eliminated.
Cost reduction from elimination of third-party verification. The decentralization makes it

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harder to meddle with. Transaction becomes more secure, efficient and private than the
ordinary system. Easier to search for information due to its transparent technology. The
Blockchain system also provides a banking alternative and ways to secure personal
information for citizens in countries that have an underdeveloped government or unstable
government.

Disadvantages:
There are some cons of the blockchain system, the significant energy consumption associated
with mining Bitcoin. The high costs associated with blockchain transactions. History of use in
illicit activities. The balance between the node’s quantity and the favourable costs of users
according to Golosova & Romanovs (2018). Some countries' governments have made
regulations on the cryptocurrencies, which is a problem since more governments can in theory
make it illegal to own cryptocurrencies or participate in their networks according to The Law
Library of Congress (2018).

4. Financial theory

4.1 Hedging
A hedge is when you reduce risk of adverse price movements in an asset or commodity.
Usually, a hedge is when one takes a counterbalance or opposite position in a related security.
Hedging is therefore a strategy that is trying to limit risks in different financial assets. To give
an example how hedging works, think of a situation where a dealer purchases a commodity at
a specific spot price and the price falls (rises) before the dealer resells it, the dealer is exposed
to a capital loss (gain). To eliminate this capital loss (gain), the dealer can protect his
inventory by selling x units of future contracts to cover delivery of x units. When the dealer
decides to resell the x units, he liquidates his position in the future by purchasing the same
number of contracts as he did in the beginning. If the spot price change is the same as the
future contracts price change (if the price has moved parallel to each other) then he has gained
his “ordinary” merchandising profit and therefore the dealer has escaped from the risk of a
residual capital gain or loss. (Johnson 1976)

Writing more specifically about hedging in investments, hedging works the same way as the
previous example with some differences and more complexity to it. Hedging is about
managing and lowering the investments exposure for risks. To hedge in the investment world,
an investor must use various instruments in a strategic fashion to offset the risk of adverse

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price movements in the market. Derivatives is a common usage in hedging in the investment
world which includes options, forward and futures contracts, swaps and securities that move
in the opposite direction of the underlying assets which most often is stocks, currencies,
commodities, bonds, interest rates or indices. Losses in an investment in the underlying asset
can be dampened with a specific hedging derivative. The effectiveness of a derivative hedge
is expressed in terms of delta, often referred to as “hedge ratio” (Hull 2018).

4.2 Strategy in hedging

According to Hull (2018) the Long/Short Equity strategy which is also the most popular
strategy is where the investors are searching for two or more stocks that are considered to be
undervalued and some that are considered overvalued. The investor takes a long position in
the undervalued stocks and takes a short position in the overvalued stocks. This strategy is all
about stock picking, if the investor chooses well, then the portfolio of stocks should generate
good returns both when there’s a bull market and also under a bear market. In general, the
investors that use this strategy are focusing on smaller stocks and do extensive research on
them with the usage of fundamental analysis, these stocks also haven’t been analyzed by other
analysts.

4.3 Diversification
This is a technique that is reducing risks by spreading one's investments in various financial
instruments, categories, and industries. This aims to maximize returns by investing in
different areas that would react differently to different kinds of events. This is leading to the
unsystematic risk being lowered. A downside of making a well-balanced and diversified
portfolio is that it can be expensive and complicated, which leads to lower rewards because
the risk is diminished. But to professional investors or fund managers this is one of the most
important components of reaching long-range financial goals while minimizing risk. (Hull
2018)

Diversification in a portfolio can easily be done by investing in different asset classes and
decide a specific weight to put in the chosen assets that’s generating the best risk-reward
characteristics. To combine assets and help find out which combinations of assets that is
generating the best risk-reward characteristics. The correlation of assets is a tool that’s used in
this situation to see the differences between assets to determine the best diversifiers and
combination of assets that can generate better risk-reward attributes.

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One diversification strategy is to invest in companies on the stock market that is operating in
different sectors and tends to have low return correlation or choose the stocks or other assets
that have different market capitalizations. Another option is to invest in foreign stocks or
assets, since foreign stocks or assets often have a lower correlation than of the domestic ones.
(Bodie et.al. 2018)

4.4 Beta as a measurement in investing

Beta is a way to measure systematic risk of an asset in relation to an index (Hull 2018). The
value given from beta can be both negative and positive. A positive beta indicates that the
stock moves in the same direction as the index investigated and a negative beta indicates an
inverse relationship where the stock moves in the opposite direction of the index. Beta is
calculated by using the following equation.

 ( , )
 = (1)
 ( )

The equation shows that the beta for the stock a is calculated by taking the covariance
between the returns of stock a ( ) and index b ( ) and dividing it by the variance of the
return of index b ( ). The value given by the equation is the systematic risk of the stock a in
relation to the index b. Beta can then be used to measure the added volatility of a portfolio
when adding stock a. This can be used to maximise returns and minimizing risk.

Beta can be both negative and positive (Hull 2018). If the value of beta is negative it indicates
an inverse relationship to the index investigated. This scenario is highly unusual, but it
indicates that the asset is a systematic risk hedge to the index. A beta of 0 means that there is
no relationship between the index and the asset, the asset will not be affected by movements
in the index. If the beta is between 0 and 1 it indicates that the asset is less volatile than the
market and including the asset in the portfolio would lower the systematic risk of the
portfolio. A beta of 1 means that there is a perfect relationship between the asset and the
index. This type of relationship is usually seen with index funds in relation to the index. A
value greater than 1 indicates that the asset is more volatile than the index and including it in
the portfolio would increase the systematic risk of the portfolio.

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4.4.1 Hedging using beta

When using beta to hedge your risk you aim to get a beta of the portfolio equal to one (Hull
2018). To do this you include assets with different beta and adjust the weight of the assets in
your portfolio to get a beta as close to one as possible. To calculate the beta of the portfolio
you use this formula.

 1 ∗ 1 + 2 ∗ 2 … + ∗ = (2)

The w in the equation means the weight of the asset in the portfolio. The weight is how much
of the total value of the portfolio that is invested in the given asset. The aim of the hedge is to
reduce the systematic risk of the portfolio. Using a beta hedge allows you to include more
risky assets.

4.5 Sharpe’s ratio

According to Bodie et.al. (2018) William F. Sharpe developed an equation which is used to
aid the investors understand the return of one's investment compared to its risk. This formula
or ratio is named Sharpe ratio. The main thing about the Sharpe ratio is that the ratio is
the average return earned per unit of volatility (this is a measure of the fluctuations in prices
for a portfolio or asset) or total risk, when looking at the profits that exceeds the risk-free
rate. By subtracting the risk-free rate to the mean return of an investment leads to an isolation
of the profits that is associated with risk for investments. Overall, the greater the value of the
Sharpe ratio, the more attractive the risk-adjusted return is. The risk-free rate of return is the
return on an investment with no risk.

Formula of Sharpe Ratio
 ( − )
 Sharpe Ratio= (3)
 
 = return of portfolio
 = risk-free rate
p = standard deviation of the portfolio’s excess return

Bodie et.al. (2018) states that using the standard deviation in the formula is going to give
implication on how much the portfolio’s return deviates from the expected return. By
adjusting a portfolio or assets past performance or expected future performance for the risk
over the risk-free rate for an investment is what the Sharpe ratio is all about. Getting a high

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Sharpe ratio is good when compared to similar portfolios or funds with lower returns. One of
the big weaknesses with the Sharpe ratio is the assumption that the investment returns are
normally distributed.

5. Data

5.1 Description of the data
The Pearson correlation test will indicate whether Bitcoin could be a hedge or diversifier
against the 11 variables included in the test. The test is made on the 6 largest indexes in the
world as well as the 5 largest currencies. The indexes that we have included in our test is S&P
500 (S&P), Dow Jones Index (DJI), Deutscher Aktienindex (DAX), Nasdaq 100 (NDX) Hang
Seng Index (HSI) and Nikkei 225 (N225). The currencies included in the test is Swiss franc
(CHF), Euro (EUR), British Pound Sterling (GBP), Japanese yen (JPY) and Australian dollar
(AUD). All the currency data is in relation to the US dollar. We have also included silver and
gold to be able to compare the results to more conventional diversifications and hedges.

The data is in weekly closing price and the range is from 2017-01-01 to 2021-02-28. The
reason that we chose this range is that after 2017 the volume of Bitcoin is at a relatively
similar rate to the other assets in the test. We chose to conduct the test on weekly prices due to
the difference in trading days between Bitcoin and the other variables. The dataset is then
separated into 3 time periods. The three time periods are 2017-01-01 to 2021-02-28, 2019-01-
01 to 2021-02-28 and 2020-01-01 to 2021-02-28.

The data is collected from Yahoo finance with three exceptions. The exceptions are the
closing weeks of September 2019 for the currencies in the investigation. The data for the
weeks were gathered from Macrobond to give us a full dataset.

5.2 Pearson correlation

According to Schober et.al. (2018) the Pearson Correlation is a production of different
samples that's based upon correlation coefficients r. This measures the strength and direction
of correlation between pairs of continuous variables. This is also testing if there’s statistical
evidence of a linear relationship among the variables in the populace.

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