Title: Is idiosyncratic risk diversifiable in cryptocurrency market?

Authors: 
Tanveer Ahmad - Department of Economics and Finance, TalTech
Tõnn Talpsepp - Department of Economics and Finance, TalTech
Syed Jawad Hussain Shahzad - University of Waikato, NZ

Abstract:

This paper examines whether the idiosyncratic volatility (IVOL) premium in the cryptocurrency market is indeed idiosyncratic risk or a missing systematic risk factor. Using a sample of over 2000 cryptocurrencies, the IVOL is calculated from the residuals of a three-factor crypto-pricing model. First, our results show a strong size dependence in IVOL premium; a positive IVOL premium in micro-cap cryptos whereas a negative IVOL premium in non-micro cryptos. Next, we test the persistence of IVOL premium through a portfolio-based approach by systematically increasing the portfolio size i.e., level of diversification. The IVOL premium diminishes (and became insignificant) as we increase the level of diversification. The results suggest that the IVOL premium is largely diversifiable and does not represent a missing systematic risk factor. Furthermore, we decompose the IVOL into its upside and downside components and recheck the diversifiability of its premium. We find that downside component of IVOL is more strongly priced in the smaller coins, and the good minus bad premium diminishes as we increase the diversification. Our findings highlight that the IVOL in crypto market is rewarded but is diversifiable. This has implication for volatility- based trading strategies.

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