The Diversification Benefits of Cryptocurrency Asset Categories and Estimation Risk: Pre and Post COVID-19
The European Journal of Finance, Forthcoming
99 Pages Posted: 3 Aug 2021 Last revised: 18 Jan 2022
Date Written: January 16, 2022
We examine the diversification benefits of cryptocurrency asset categories. To mitigate the effects of estimation risk, we employ the Bayes-Stein model with no short-selling and variance-based constraints. We estimate the inputs using lasso regression and elastic net regression, employing the shrunk Wishart stochastic volatility model and Gaussian random projection. We consider nine cryptocurrency asset categories, and find that all but two provide significant out-of-sample diversification benefits. The lower is investor risk aversion, the more beneficial are cryptocurrencies as portfolio diversifiers. During uncertain economic environments, such as the post-Covid-19 period, cryptocurrencies provide the same diversification benefits as in more stable environments. Our results are robust to different portfolio benchmarks, regression technique, transaction cost, portfolio constraints, higher moments and Black-Litterman models.
Keywords: Cryptocurrencies; COVID-19; Bayes-Stein; Lasso; Elastic net; Shrunk Wishart stochastic volatility; Gaussian random projection; Black-Litterman; Higher moments
JEL Classification: G11, G12
Suggested Citation: Suggested Citation