Summary:
- One factor that analysts should always consider is the sharp drops in cryptocurrencies prices.
- Non-parametric value at risk analysis is compatible with the volatile nature of cryptocurrency prices.
- From a value at risk analysis point of view, Bitcoin may seem to be the safest choice.
Cryptocurrencies are vastly known for their volatile nature. You could almost never see that much fluctuation in other more established financial markets. Cryptocurrencies have also shown significant fat tail risk in the past.
Therefore, one factor that analysts and investors should always consider when evaluating cryptocurrencies is their volatility, especially sharp drops in prices. Most of the time prices slump due to unfavorable news about projects fundamentals, regulatory actions against cryptocurrencies, market participants' overreactions, or market illiquidity. Nevertheless, people should always be careful about cryptocurrencies price crash risk.
One of the risk measures that is suitable for evaluating cryptocurrencies price crash risk is the non-parametric value at risk (VaR). Unlike measures like variance or CAPM Beta, non-parametric value at risk analysis is compatible with the volatile nature of cryptocurrencies prices and their large leptokurtosis that also shows that they do not follow a normal distribution.
One important advantage of non-parametric VaR is that we can calculate it based on the historical performance of cryptocurrencies prices rather than assuming a distribution probability. Therefore, we could work with actual scenarios that happened in the past. They may not happen again in the future but they are more realistic than other types of assumptions.
VaR calculates the maximum expected loss, over a given time period and given a specified level of confidence. In the historical non-parametric VaR approach, we calculate VaR directly from past returns. In this article, I calculated VaR using 100 daily returns and set the level of confidence to 95%. Since we are using daily returns, we are actually finding the worst daily shocks in the past 100 days of a cryptocurrency's price movements.
The sample under consideration consists of the top 30 cryptocurrencies with the highest market capitalization, according to coinmarketcap.com (accessed on December 28, 2021), which are not stable coins or wrapped tokens.
Table 1 outlines the calculated non-parametric VaRs and I have also sorted our sample cryptocurrencies based on their VaR. For example, with 95% confidence, we expect that Bitcoin’s worst daily loss will not exceed -5.7%, Shiba’s worst daily loss will not exceed -12.5%, and so on.
Table 1: Cryptocurrencies Non-Parametric Value at Risk
: Author’s calculations, coinmarketcap.com
Figure 1: Cryptocurrencies Non-Parametric Value at Risk Histogram
: Author’s calculations
As Figure 1 depicts, based on my calculations, 11 or more than 36% of cryptocurrencies under consideration had a VaR between -7.4% to -9.1%. Only one cryptocurrency’s VaR was higher than -10.8% (Shiba) and also only one cryptocurrency’s Var was lower than -5.7% (Bitcoin).
The low VaR of Bitcoin is not a surprise because it has the most liquid market and also it is more adopted by individuals and institutions around the world than any other cryptocurrency. We can conclude that more adoption can result to lower VaR.
Therefore, from a VaR analysis point of view, Bitcoin may seem to be the safest choice. However, keep in mind that VaR is just one of the many factors to consider when evaluating cryptocurrencies.
