Title [The impact of inflation and estimation risk on portfolio management with cryptocurrencies
and Bitcoin]


1. Introduction

Cryptocurrencies have gained tremendous popularity in recent years, and their significance in the
investment market has been rapidly increasing. The unpredictability and high volatility of the
cryptocurrency market have led to increased attention towards risk management in cryptocurrency
portfolios. Hedging strategies have been widely used to protect the downside risk of commodities
through cryptocurrencies. However, it remains unclear how effective these strategies are in the
cryptocurrency market. The relevance of this research lies in its potential to provide insights
into the effectiveness of hedging the downside risk of commodities through cryptocurrencies.
Understanding the effectiveness of these strategies is crucial for investors and financial
institutions who are looking to incorporate cryptocurrencies into their investment portfolio. The
research problem also addresses the need to explore the risk management of cryptocurrencies, which
is becoming increasingly important as more investors and institutions are investing in
cryptocurrencies. The research aims to investigate the risk management strategies that can be used
to minimize the downside risk of commodities through cryptocurrencies.


2. Literature review

Several studies have examined the diversification benefits of cryptocurrencies in a portfolio
context. Dorfleitner and Lung (2018) re-examined the diversification benefits of cryptocurrencies
from the perspective of Euro investors and found that cryptocurrencies can provide diversification
benefits for long-term investors. They also identified a day-of-the-week effect, where the returns
on Bitcoin are highest on Mondays and lowest on Saturdays. This finding suggests that investors
should consider the day-of-the-week effect when deciding on the optimal allocation of
cryptocurrencies in their portfolio (Dorfleitner & Lung, 2018).

The Role of Estimation Risk," Platanakis and Urquhart (2019a) explore the role of estimation risk
in portfolio management with cryptocurrencies. Estimation risk refers to the uncertainty associated
with the estimation of the parameters of the asset return distributions, which is particularly
relevant in the case of cryptocurrencies due to their high volatility and non-normal distribution
characteristics. The authors argue that traditional portfolio optimization models that assume
normal distribution of returns and constant variance may not be appropriate for cryptocurrencies
and may lead to suboptimal portfolio allocation decisions. The authors propose a novel portfolio
optimization model that accounts for estimation risk through a Bayesian approach, which allows for
the incorporation of prior information and the updating of portfolio weights as new data becomes
available. The results of their empirical analysis suggest that the incorporation of estimation
risk improves portfolio performance and reduces downside risk (Platanakis & Urquhart, 2019a).

Naeem et al. (2021) proposed a hedging strategy for the downside risk of commodities using
cryptocurrencies. They found that a portfolio of Bitcoin and Gold can effectively hedge against the
downside risk of commodities, and that the optimal allocation of Bitcoin varies depending on the
level of risk aversion of the investor. This finding suggests that investors can use
cryptocurrencies not only for portfolio diversification but also for hedging against specific risks
(Naeem et al., 2021).


The author states that the extreme volatility and rapid changes in the cryptocurrency market make
it challenging to predict future prices and risks. The article discusses the application of the
GARCH model in estimating VaR, which is the maximum potential loss a financial institution may
suffer within a specific period. Obeng (2021) evaluates the effectiveness of the GARCH model by
analyzing data from Bitcoin, Litecoin, and Ethereum markets between 2015 and 2020. The results show
that the GARCH model effectively estimates VaR in the cryptocurrency market, and its accuracy
outperforms other traditional models. The study also finds that the cryptocurrency market exhibits
a high level of volatility, and the VaR estimates obtained from the GARCH model vary depending on
the chosen confidence level. The article contributes to the existing literature by highlighting the
effectiveness of the GARCH model in predicting risks in the cryptocurrency market. The study also
shows that the GARCH model is superior to traditional models and can be used by financial
institutions and investors to manage risks in the cryptocurrency market. Furthermore, the study
highlights the importance of the confidence level in VaR estimation, which is crucial for making
informed investment decisions (Obeng, 2021).

Blau, Griffith, and Whitby (2021) explored the relationship between inflation and Bitcoin, using
descriptive time-series analysis. The authors acknowledged the increased interest in Bitcoin as a
potential hedge against inflation in recent years, particularly after the COVID-19 pandemic. The
study's main objective was to examine whether Bitcoin could serve as an inflation hedge. The
authors used daily data from January 2012 to March 2021 and employed time-series techniques to
explore the relationship between inflation and Bitcoin. The study's findings revealed that Bitcoin
was not a reliable inflation hedge. The authors found that Bitcoin's correlation with inflation was
generally weak and inconsistent, implying that the cryptocurrency's value did not reliably rise in
response to inflation. Furthermore, the authors found that the relationship between Bitcoin and
inflation varied over time. In particular, they found that Bitcoin's response to inflation was
stronger in the early years of the sample than in the later years. This suggests that Bitcoin's
inflation-hedging ability may have weakened as it became more popular (Blau et al., 2021).


The study by Phochanachan et al. (2022) aims to shed light on this debate by examining whether
Bitcoin and traditional financial assets act as an inflation hedge during stable and turbulent
markets, using data from countries with high cryptocurrency adoption. The authors use a variety of
statistical methods to analyze the data, including regression analysis and Granger causality tests.
The findings of the study suggest that Bitcoin and traditional financial assets can act as an
inflation hedge during both stable and turbulent markets. Specifically, the authors find that
Bitcoin and traditional financial assets have a negative relationship with inflation, meaning that
as inflation increases, the value of these assets tends to increase as well. Additionally, the
authors find evidence of a bidirectional causality between Bitcoin and inflation, suggesting that
changes in Bitcoin prices can influence changes in inflation, and vice versa. While the study
provides compelling evidence that Bitcoin and traditional financial assets can act as an inflation
hedge, there are some limitations to consider. For example, the study only focuses on countries
with high cryptocurrency adoption, which may not be representative of the broader global market.
Additionally, the study does not consider the potential impact of other macroeconomic factors, such
as interest rates or exchange rates, on the relationship between Bitcoin and inflation
(Phochanachan et al., 2022).


3. Conclusion

The growing interest in cryptocurrencies as a potential investment option, both for diversification
and as a safeguard against particular risks, is highlighted by this literature review, which comes
to a conclusion. The studies covered in this review shed light on several market aspects, including
volatility, risk management, inflation, and the market's connection to conventional financial
assets.

The review emphasizes how cryptocurrencies, like Bitcoin, can benefit from diversification and
possibly serve as a safety net against downside risks. It is difficult to accurately forecast
future prices and risks due to the cryptocurrency market's extreme volatility and rapid changes. As
a result, it is essential to implement effective risk management techniques, such as estimating
value at risk using models like GARCH.

The studies also indicate that the relationship between cryptocurrencies and inflation is weak and
inconsistent, suggesting that it may not reliably serve as an inflation hedge. However, Bitcoin and
traditional financial assets can act as an inflation hedge during both stable and turbulent
markets, providing investors with a potential avenue to manage inflationary risks.

Overall, the literature reviewed here suggests that cryptocurrencies, particularly Bitcoin, can
provide valuable opportunities for investors seeking to diversify their portfolios or manage
specific risks. However, investors must be aware of the risks associated with the cryptocurrency
market and employ appropriate risk management strategies. These findings can inform the question of
how to approach investment decisions in the cryptocurrency market and highlight the importance of
considering diversification and risk management strategies.


4. Resources:

Blau, B. M., Griffith, T. G., & Whitby, R. J. (2021). Inflation and Bitcoin: A descriptive
time-series analysis. Economics Letters, 203, 109848. https://doi.org/10.1016/j.econlet.2021.109848

Dorfleitner, G., & Lung, C. (2018). Cryptocurrencies from the perspective of euro investors: a
re-examination of diversification benefits and a new day-of-the-week effect. Journal of Asset
Management, 19(7), 472–494. https://doi.org/10.1057/s41260-018-0093-8

Naeem, M., Farid, S., Shahzad, S. J. H., & Shahzad, S. J. H. (2021). Hedging the downside risk of
commodities through cryptocurrencies. Applied Economics Letters, 28(2), 153–160.
https://doi.org/10.1080/13504851.2020.1739609

Obeng, C. (2021). MEASURING VALUE AT RISK USING GARCH MODEL - EVIDENCE FROM THE CRYPTOCURRENCY
MARKET. International Journal of Entrepreneurial Knowledge, 9(2), 63–84.
https://doi.org/10.37335/ijek.v9i2.133

Platanakis, E., & Urquhart, A. (2019a). Portfolio Management with Cryptocurrencies: The Role of
Estimation Risk. Social Science Research Network. https://doi.org/10.2139/ssrn.3287176

Phochanachan, P., Pirabun, N., Leurcharusmee, S., & Yamaka, W. (2022). Do Bitcoin and Traditional
Financial Assets Act as an Inflation Hedge during Stable and Turbulent Markets? Evidence from High
Cryptocurrency Adoption Countries. Axioms, 11(7), 339. https://doi.org/10.3390/axioms11070339