Portfolio Optimization with Digital Currencies based on Risk Parity Model: A Case Study of Bitcoin

DOI: https://doi.org/10.62517/jse.202611212

Author(s)

Zhongxue Zhu

Affiliation(s)

International Business School Suzhou, Xi’an Jiaotong-Liverpool University, Suzhou, Jiangsu, China *Corresponding author

Abstract

The challenges facing the traditional 60/40 portfolio have prompted exploration into digital assets like Bitcoin for diversification, despite their extreme volatility. This study investigates the integration of Bitcoin into a traditional portfolio using a risk parity approach. We construct and compare a standalone Bitcoin, a traditional 60/40 portfolio consisting of the SPTR500 index and the IEF, and a new risk parity portfolio weighted by the inverse of volatility. Employing the EGARCH(1,1) model for volatility analysis and historical simulation for Value at Risk (VaR) and Expected Shortfall (ES), the empirical results show that the new risk parity portfolio achieves a significantly higher Sharpe ratio and lower tail risk, with extreme losses between -3% and -4%. The study concludes that strategic inclusion of Bitcoin within a dynamically weighted portfolio can significantly enhance overall performance, providing empirical support for integrating digital assets.

Keywords

Bitcoin; Portfolio Optimization; Risk Parity Model; EGARCH Model; Value at Risk (VaR); Expected Shortfall (ES)

References

[1] Baur, D. G., Hong, K., Lee, A. D. (2018) Bitcoin: Medium of exchange or speculative assets? Journal of International Financial Markets Institutions and Money, 54: 177-189. [2] Jing, Y., LI, H.Q., Ren, S.H., Wang, Y., Huang, C., Xu, L.Q. (2021) Analysis of Bockchain Digital Currency and Market Risk Based on VAR. International Conference on Computer, Blockchain and Financial Development (CBFD). [3] Corbet, S., Lucey, B., Urquhart, A., Yarovaya, L. (2018) Cryptocurrencies as a financial asset: A systematic analysis. International Review of Financial Analysis, 62: 182-199. [4] Dyhrberg, A. H. (2016) Hedging capabilities of bitcoin. Is it the virtual gold?. Finance Research Letters, 16: 139-144. [5] Nelson, D. B. (1991) Conditional heteroskedasticity in asset returns: A new approach. Econometrica, 59: 347-370. [6] Acerbi, C., Tasche, D. (2002) Expected shortfall: a natural coherent alternative to value at risk. Economic Notes, 31: 379-388. [7] Cheah, E. T., Fry, J. (2015) Speculative bubbles in Bitcoin markets? An empirical investigation into the fundamental value of Bitcoin. Economics Letters, 130: 32-36. [8] Kazemi, H. (2011) An Introduction to Risk Parity. Alternative Investment Analyst Review [9] AlHalaseh, R.H., Shawawreh, F.K.A. (2024) Enhancing Portfolio Optimization: A Comparative Analysis of The Mean-Variance Markowitz Model and Risk-Parity Contribution Strategies. Corporate & Business Strategy Review, 5: 124-136. [10] Brière, M., Oosterlinck, K., Szafarz, A (2015) Virtual currency, tangible return: Portfolio diversification with bitcoin. Journal of Asset Management, 16: 365-373.