Throughout 2020, numerous perspectives emerged regarding the relationship between cryptocurrencies and major asset classes. This article outlines the market correlations and volatility between major cryptocurrencies—Bitcoin and Ethereum—and traditional asset classes such as stocks, foreign exchange, and precious metals. The goal is to better understand market movements and improve risk management strategies.
Understanding Volatility and Correlation
In financial markets, risk is often defined by volatility, which measures the general magnitude of price fluctuations over a specific period. Higher risk corresponds to greater volatility, increasing the potential for both significant gains and losses. In modern finance, investors expect compensation for assuming non-diversifiable risk: the greater the risk, the higher the expected return. However, during crises, this relationship can reverse, leaving investors facing substantial risk with little to no reward.
Beyond the volatility of individual assets, another cornerstone of risk allocation and asset配置 is how assets interact—specifically, how they correlate with one another. Estimating these correlations is challenging, especially in highly non-stationary environments, without delving into complex mathematical concepts like random matrices.
Methodological Approach: Exponential Moving Average
This analysis employs calculations based on exponential moving averages to provide a more robust picture of 2020’s volatility and correlation dynamics. The primary advantage of this method is its emphasis on recent events over distant ones, preventing irregularities from the distant past from disproportionately influencing current values. The results shown here use the RiskMetrics Group approach with a decay factor of 0.94.
The asset classes examined include:
- Cryptocurrencies: Bitcoin and Ethereum
- Stock Index: S&P 500
- Foreign Exchange: Represented by the U.S. Dollar Index (DXY)
- Precious Metals: Gold (XAU)
Correlation Evolution in 2020
Figure 1 illustrates how correlations between Bitcoin and other assets—Ethereum, S&P 500, U.S. Dollar Index, and Gold—have evolved since January 2020. A correlation of 1 implies perfect synchronous movement with Bitcoin’s price, while -1 indicates opposite movements. The "safe haven" narrative for Bitcoin suggests low or negative correlations with traditional markets, though history has not always supported this.
March 12 Market Crash Impact
On March 12, following the COVID-19-induced market crash, correlations surged abruptly. While the U.S. Dollar Index (DXY) quickly reversed its trajectory, the high correlation between the S&P 500 and Bitcoin persisted for an extended period. This correlation only recently began to weaken as investors announced significant allocations to Bitcoin, driving its price to unprecedented levels.
Bitcoin-Ethereum Dynamics
Historically, Ethereum has shown high correlation with Bitcoin, especially from March to August 2020. Starting in mid-year, this correlation became more volatile, likely in response to the DeFi boom and uncertainties surrounding the transition to Ethereum 2.0. On November 24, just before the Beacon Chain launch on December 1, the correlation between Ethereum and Bitcoin hit a low of 0.14.
Volatility Comparisons
Figure 2 compares the historical volatility of the same assets. It indicates that while volatility has decreased since the March crash, the S&P 500’s volatility remains higher than its January-February levels.
Figure 3 shows the ratio of Bitcoin’s volatility to that of each asset. A value of 2, for example, means Bitcoin was twice as volatile as the corresponding asset. Before the March crash, Bitcoin’s volatility was relatively subdued compared to traditional assets. However, the "Crypto Black Thursday" on March 12 revealed weak resilience, followed by a volatility spike due to liquidation spirals driving prices to extreme lows.
Key Findings and Implications
Correlations between Bitcoin and major asset classes followed distinct mechanisms in 2020:
- Bitcoin’s correlation with the stock market (S&P 500) rose to relatively high levels and persisted for some time.
- Its correlation with gold (XAU) remained low throughout the year.
The ratio of Bitcoin-to-S&P 500 volatility reached historical lows in 2020, with both assets exhibiting nearly identical volatility from early to mid-March. However, volatility in the cryptocurrency market began surging again in November due to the ongoing bull run.
Bitcoin and Ethereum were highly correlated from the March crash until the DeFi summer boom, but this relationship experienced strong temporary decoupling as the first phase of the Ethereum 2.0 transition approached. Monitoring this relationship remains intriguing, especially with increasing trading volume in Ethereum markets and the introduction of institutional derivatives like the CME’s Ethereum futures, announced for February 2021.
As 2020 concluded, the financial outlook for Bitcoin and cryptocurrencies turned highly optimistic. With more institutional capital entering the space as a means of diversification and hedging against economic uncertainty, correlations between major cryptocurrencies and stock markets have recently moved into negative territory.
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Frequently Asked Questions
What is volatility in financial markets?
Volatility measures the degree of variation in an asset’s price over time. Higher volatility indicates greater price swings, implying higher risk and potential return. It is a key metric for assessing investment risk and making informed trading decisions.
How does correlation affect portfolio diversification?
Correlation indicates how two assets move in relation to each. Low or negative correlations between assets can enhance portfolio diversification, reducing overall risk. If assets are highly correlated, they may move together, diminishing diversification benefits.
Why did Bitcoin’s correlation with stocks increase in 2020?
During market stress events like the COVID-19 crash, investors often liquidate assets across the board, leading to temporary spikes in correlation. Bitcoin’s growing institutional adoption also contributed to its closer alignment with traditional markets during parts of 2020.
Is Bitcoin a safe haven asset like gold?
While some investors view Bitcoin as a digital safe haven, its correlation with gold has generally been low. Bitcoin’s behavior during crises has been mixed, sometimes correlating with risk assets rather than acting as a hedge.
What caused the decoupling between Bitcoin and Ethereum in late 2020?
The anticipation and launch of Ethereum 2.0’s Beacon Chain, along with the DeFi boom, created unique supply and demand dynamics for Ethereum, leading to temporary periods of decoupling from Bitcoin’s price movements.
How can investors manage volatility in cryptocurrency investments?
Investors can manage volatility through diversification, position sizing, and using risk management tools like stop-loss orders. Understanding market cycles and staying informed about macroeconomic factors also helps in navigating volatile markets.