Correlation quantifies the extent to which movements of two investment assets are interconnected. The values can vary from -1 to +1, with the former referring to the perfectly inverse correlation. This rate is especially important for investors as it allows one to realise the diversifiable risk associated with combining multiple assets into a single market portfolio.
Therefore, while constructing a business portfolio, it is possible to mitigate the both company-specific and market-specific risks, with the addition of risk differentiation associated with diverse business models. Below, the case of several cryptocurrencies is given, and the meaning of such a combination for the business peculiarities of the market is discussed.
ICP versus QNT
ICP vs QNT: According to the source, the 3-month correlation between Internet Computer and Quant is equal to 0.47, with a positive meaning. This implies that their trajectories are positively directed though they do not move in perfect unison. The overlapping area between the two assets is the risk that can be dispersed if an investor holds the two in one market portfolio.
One can go short in the case of ICP crypto and long for QNT. A possible way to hedge some risks is to go long with one and short with the other because digital currencies operate in separate market niches, each with its own technological underpinnings. In totality, the hedging strategy should work because the correlation between the two coins is positive, but moderate.
LTC versus BTC
The correlation coefficient of Litecoin (LTC) to Bitcoin (BTC) in the three-month horizon is significantly higher than the prior case. Specifically, this rate is equal to 0.9, indicating an extremely strong direct correlation. This significant correlation is attributed to the fact that Litecoin was designed to be a lighter and quicker version of Bitcoin. Because of that, the online communities refer to LTC as silver Bitcoins, and it is often stored this way.
To that end, although pair trading for LTC and BTC can assist in hedging some of the unsystematic risks, the strong correlation suggests that market changes that affect Bitcoins would have almost the same effect on Litecoin. Hence, the power of diversifying between these assets will be negligible if the ultimate goal is lower exposure to total portfolio risk.
Implications for Portfolio Diversification
Digital assets grant high-return potential for portfolio builders who include digital coins like ICP, QNT, BTC, and LTC. The primary reason why this strategy may fail is the varying degree of correlation between these investments. In that regard, it is suggested that pair investments for ICP versus QNT or LTC to BTC will not lead to suitable risk reduction for the following reasons.
First, the strong correlation between two features of LTC and BTC pinpoints to a specific shortcoming, as LTC is confirmed to move in the same direction when the market is either dropping or moving in a volatile manner. As such, if individuals are seeking to hedge LTC with BTC or another way around, there are no means to mitigate financial risk coming from exposure to the market as it is. Second, the crypto market is known for its intense fluctuations and rapid evolution, meaning that the correlations provided above could change drastically. Hence, the use of these pairs diversification will increase the risk above the levels that investors anticipated.
If investors want to apply a more diversified strategy, they should focus on broader classes of assets rather than just these three given cryptocurrencies. It might refer to crypto assets with lower or even negative correlations. Various asset classes or sectors of the economy should be explored alongside crypto assets that differ by their mechanisms or use cases, or by the market drivers they are affected by. In these ways, unsystematic risks will be more likely reduced, and the portfolio would be less subject to strong volatility.
