What to Do to Decrease Your Cryptocurrency Risk. And How to Calculate it.
All investments come with risks. How can you identify, calculate, and lower them?
Quick question: How many types of risks do you think there are in cryptocurrency trading? Chances are, most investors are not able to identify, much less calculate their risk exposures because they don’t think much about it.
To many traders, taking on risk is but a minor inconvenience. Cryptocurrency markets have made us extremely desensitised to risk. 20% downsides and 50% upsides are so common that it makes the 50% stock market crash in 2008 look like child’s play. Moreover, the current bull market makes risk management seem superfluous to most retail traders: who cares about risk management since Dogecoin is going to the moon?
However, this article aims to shed light on why risk management is important. It will illustrate the two main types of risks, how you can calculate them, and how you can minimise them.
Systematic risk
Simply put, systematic risk is the risk you take on that is inherent to the market and you incur as an investor in the crypto market. This could be due to Macroeconomic events such as inflation and interest rates, or even environmental factors such as floods (which caused disruptions in Bitcoin mines).
As seen in the graph below, increasing the number of assets in order to diversify does not decrease the systematic risk.
Image credit: Corporate Finance Institute
To quantify systematic risk, we can often perform regression analysis of daily returns in the Cryptocurrency Index and daily returns of the coin you’re trading. Crypto indexes are essentially an estimate of how well the crypto market is doing. You can obtain such index data from CRIX.
To perform the regression, prices should be converted to daily returns. Returns can be found using the formula below
Returns t represents the returns on a specific date, price t represents the closing price of the date, and price t-1 represents the closing price of the previous day.
For the purpose of illustration, Cardano (ADA) prices will be used to calculate its systematic risk. It is chosen because it has an interesting relationship with the main cryptocurrency market.
To start, we simply performed the regression on Excel. Here’s a tutorial to get you started. After performing regression, the coefficient highlighted in the table below would be your structural risk.
The negative value of systematic risk (-0.0426) would suggest that ADA and the crypto market have an inverse correlation. That is, as the returns of the crypto market decrease, ADA returns seem to increase and vice versa. However, because the absolute value is small, the extent of the inverse correlation is small. You can check out the excel sheet here for the calculations.
To improve the precision or accuracy of the systematic risk, you can increase the number of data points or use hourly data. Our analysis used a quarter’s worth of daily data.
KEY POINT:
When you perform your own regression for other coins, different results will be returned. In general, a positive systematic risk signals a positive correlation, while a negative systematic risk signals a negative correlation.
As a general rule of thumb, a rational investor would choose an asset with the smallest systematic risk.
Unsystematic risk
As opposed to systematic risk, unsystematic risks specific to the cryptocurrency. For instance, Dogecoin suffers high unsystematic risk from the Tweets of Elon Musk. When Elon Musk tweets something about a dog, the price of Dogecoin seems to be heavily influenced.
Image credit: Elon Musk Twitter
Another example would be XRP Ripple. Legal issues with the US Securities and Exchange Commission (SEC) often embroil this coin with FUD. This results in huge downside unsystematic risks when investing in it.
Now, how do we calculate unsystematic risk? Firstly, we would first have to find the total variance of the asset. Variance is the spread between the price returns of an asset. Using the example of ADA, we can find the asset variance using the formula below.
In essence, Variance sums up the difference between individual returns to the average return and divides it by the sample size minus one. The value of variance is approximately 0.267.
Next, Unsystematic risk is simply Total variance — Systematic risk. This provides us with an unsystematic risk of 0.0.309 (as highlighted in yellow). This calculation can also be assessed on the Google sheets here.
While these numbers seem to be unuseful individually, they are extremely powerful indicators when comparing various crypto assets.
KEY POINT:
As a rule of thumb, unsystematic risk can be diversified away by investing in other assets which have different correlations. For instance, Cardano could be diversified with gaming crypto, which is rather insulated from main market movements. More about diversification will be explained in the next section
Calculating Value at risk
Now that we have identified and calculated the two main components of risk, it is time to quantify our total value at risk.
Value at Risk (VaR) tells us the maximum amount of funds that can be lost given normal market conditions. Calculating VaR allows us to quantify the riskiness of assets and allows us to minimise our losses.
For instance, if the 95% monthly VaR for ADA is $10,000, that means that there is a 95% confidence that your ADA would not lose more than $10,000.
For starters, I will be calculating my VaR for $100k of my ADA. To calculate my VaR I first determined the monthly Standard Deviation of ADA. This standard deviation is simply the square root of the variance we have calculated earlier.
Then, we simply computed VaR using the formula below. The Z score is simply the Normal Inverse of the confidence interval, 0.95 (this is found with the formula =NORMSINV(0.95)).
Using the formula above, we calculate a VaR of $24,529.47. That means that there is 95% confidence that the portfolio will lose not more than 24.5% of the portfolio in the month.
To further decrease our value at risk, we could increase the number of assets we invest in. Essentially, we are diversifying our portfolio. For the purpose of our demonstration, we will be adding Fortune Coin (FOC) into our portfolio. 50% of the funds will be invested in ADA and 50% invested in FOC.
However, with two assets in our portfolio, we have to calculate the covariance of ADA and FOC. The formula of covariance is given below.
With this formula, we arrived at a value of -0.00338.
Next, we will find the standard deviation of our portfolio comprising ADA and FOC using the formula below. Because this portfolio has two assets, the standard deviation is less straightforward. W signifies the weightage, which is 50%, Var represents variance, and Cov represents the covariance of ADA and FOC.
The result of the standard deviation is 0.358. If you recall, the standard deviation of a portfolio comprising ADA is 0.517, this means that there is a higher risk in a portfolio of just ADA than a portfolio of both ADA and FOC.
Lastly, the VaR is calculated using the same formula. The resultant VaR for this portfolio is 16,984.57. That means that there is a 95% confidence that the portfolio of ADA and FOC will lose no more than $16,984.57 of the portfolio.
KEY POINT:
Comparing the portfolio of just ADA and the diversified portfolio of both ADA and FOC, we see that the VaR is lower in the diversified portfolio (24.5k versus 16.9k highlighted in yellow)
This is a huge reason why diversification is an extremely important tool in financial risk management. Generally, increasing the number of assets decreases the Value at risk.
For your own analysis, you may access the Google sheets for the above calculations here.
Conclusion
This article discussed what systematic and unsystematic risks are and how you can calculate them. It also illustrated how you can calculate the value at risk of your own portfolio. In general, increasing the number of assets in your portfolio will decrease your value at risk.
To find out more about what you can do to hedge against downside risks, check out this article on what you can do when the cryptocurrency market collapses.
If you’re interested in how you can improve your trading strategies, you could also check out some tips on how to improve yourself.
This article is purely educational content and not meant as financial advice. Please perform your own research when investing.
To learn more about the complex crypto market, Fortune Coin (FOC) will be releasing a crypto webinar for all to join. It will be a free one-hour session on Oct 20 UTC 12pm (8pm Singapore Time). You can reserve a slot here or simply scan the Qr code to register.
