Bitcoin we as investors handle it? Background Info

has been everywhere in the news, from financial journals to the mainstream
newspapers as the crypto currency approaches 20,000 USD$ after being worth less
than 1,000 dollars this time one year ago. So what exactly is Bitcoin? How has
it managed a return of over 2000% in the past year? And the most importantly
how should we as investors handle it?


Background Info

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            First what is Bitcoin?  Bitcoin is a cryptocurency, what this means is
that it is digital or virtual currency that is completely decentralized and not
tied to any sort of government or regulatory agency like the traditional
currencies. The idea behind this was to have a currency that could easily be
traded between anyone, anywhere around the world.  While at the same time having a currency that
is immune to government interference, preventing the government from
manipulating how much the currency is worth. The way transaction work is
through the block chain system, which is essentially a giant online public
ledger that tracks who owns how much Bitcoin. In total there are 21 million Bitcoins
that can ever exist (Reiff, 2017), because of this limit there should not be a
devaluation of Bitcoin as more is pumped in the system since there can be any
extra Bitcoin after the 21 million, so no inflation. This is in direct contrast
to traditional fiat currency where governments can, and are known for printing
money for various reasons which devalues existing currency.




The intrinsic value
of Bitcoin

            As of the time writing a Bitcoin sits at approximately
17,930 USD, but what is the intrinsic value of this Bitcoin, meaning what is
its real value. When we think of a stock the intrinsic value is found through
the Dividend discount model. Where P=D1/(1+r)1+ D2/(1+r)2…
Essentially this formula is saying that the value of the stock should be equal
to all the future cash flows discounted to present time. When we try to apply
this theory to Bitcoin there is a big problem, Bitcoin produces no cash flows
and thus using this equation its intrinsic value would equal zero. Another
common way to calculate the intrinsic value is through valuation multiples.
This method uses a companies financials ratios like (P/E) or (EV/EBIT) and
compare them to a similar company to find the value. However since Bitcoin has
no earnings or income and thus we would get 0. Bitcoin cannot be compared to
other commodities either, like lumber or steel where there intrinsic value is
the value of them used in construction or for any other reason. Since Bitcoin
has no use other than as an asset to hold or trade. So it seems that from what
we can conclude Bitcoin indeed has no intrinsic value.


Source of the value

            So how can an asset with no
intrinsic value be worth almost 20,000 dollars per singular Bitcoin and have a
market cap of 300 billion dollars (coinmarketcap, 2017) something simply
doesn’t add up. There are two prevailing views on this. The first one is that
Bitcoin is a massive bubble that will unavoidably pop and lose all or most of
its value. As of December 12 Bitcoin had gone up 47% in a week, 181% in a month
and 2,119% in a year, and yet it has seen no increase in intrinsic value or
even in its use as it is no more common to purchase items with Bitcoin than a
year ago(Shane 2017).

            When an assets market value
increases significantly faster than its intrinsic value is when we usually see
bubbles appear. For Bitcoin many have gone so far as to compare it to the
biggest bubble in history, the tulip mania of the 17th Century
(Shane, 2017). In the 17th Century tulip buds were introduced to the
Netherlands for the first time, and everyone wanted them tulips had no or very
little intrinsic value and yet the price went so high that records from the
time show people were getting loans with their house as collateral in order to
purchase the tulips, in the hopes they could re-sell them at an even greater
price (Shane, 2017). As expected the bubble eventually bursted and the value of
the tulips fell to what it should have always been which is no more than any
other flower. Leading to people who purchased at the high price to lose a lot
of money.

            If Bitcoin is indeed the modern day
tulip buds then investors not consider it as a reasonable investment, since
when the bubble pops all of the value will be gone. However, there is another explanation
as to why Bitcoin has gathered its value and it is a reasoning that leads to
believe that its value will continue to increase. The theory is that Bitcoin is,
and more importantly will be a form of store of value, an asset where people
can store their money without worrying of what will happen to their local
currency. Historically there has been a financial instrument that has plaid the
same role, gold. Historically many people have chosen to put some of their
wealth into gold, but why? Gold like Bitcoin has no real intrinsic value as a
metal with no construction value. It can be used in jewelry which would give
some intrinsic value but not enough for people to chose to purchase it and
store bars of gold. In his article Oscar William-Grut finds a fascinating
similarity between gold and Bitcoin. Historically gold has been a popular
purchase when risk and uncertainty in the economy are high, as investors seem
to favor gold. The same seems to have happened with Bitcoin when Donald Trump
won the United States presidential election in a surprise way. Bitcoin had one
of its biggest spikes and ended that month on what at the time was a record
high.  Bitcoin could replace gold and do
it in a more efficient way. If people don’t want to have all of their money in
their local currency or invested in stock or other assets Bitcoin provides the
perfect value storage option. Graph #1 shows the value of the Bolivar, Venezuela’s
national currency compared to the dollar on a year-by-year basis.  As recently as 2007 one bolivar was
equivalent to .45 USD, as of 2017 it is at about .1 so every one in Venezuela
who had saved in their national currency saw a huge amount of their value
disappear in front of their eyes because of a poorly run government.  Bitcoin also has some clear advantages over
gold, it can easily be transferred anywhere in the world and can even be split
into tiny pieces.


Conclusion Bitcoin

            So if by traditional intrinsic value
we conclude that Bitcoin has zero value is it actually worth 0? The answer to
that is probably no. As stated Bitcoin could have a very important use, as a
form of “percent day” gold which would validate its market price. However, the
bubble aspects are very hard to ignore and an even bigger concern is that other
crypto currencies could substitute Bitcoin. Thus investors should treat it as a
very risky asset and be very careful if they choose to invest. Since unlike
stocks and bonds there are no cash flows to support its high purchase price but
essentially only speculation as to what it may eventually be.


Bitcoin Arbitrage

            Although Bitcoins high volatility and lack of
intrinsic value can make Bitcoin a scary investment there is another way in
which investors can take advantage of Bitcoin, arbitrage. Arbitrage as
explained in class arises when an investor can make riskless profits without
making a net investments. In theory real arbitrage shouldn’t exist as the
market would autocorrect itself to eliminate it. However, there appear to be
arbitrage opportunities with Bitcoin.  Currently there are two ways that arbitrage is
possible with Bitcoin. The first one is through Bitcoin futures. Bitcoin
Futures were introduced earlier this month by CBOE (Levin, 2017). The futures
essentially are a contract to agree on a set price for a Bitcoin at a future
point in time. In Matt Levine’s article he found out that as of December 12 of
this year the future contracts for a month were at 18,000 USD, while the price
of a Bitcoin was 16,889 USD so you could sell a future contract, which means
that in one month you are agreeing to sell one Bitcoin for $18,000 , regardless
of what the price of Bitcoin is at the time. At the same time you buy a Bitcoin
and you essentially make $1,111 or 6.58% risk free return in just one month,
selling multiple futures and buying the equivalent amount of Bitcoin could
multiply this profit. To make it real arbitrage there would have to be 0
initial investment and this can be done by borrowing the initial funds. Thus
the actual arbitrage number would be $1,111 or 6.58% minus the cost of borrowing.
If cost of borrowing is less than 6.58% it would be possible to create an
arbitrage opportunity.


            There is another opportunity for
Bitcoin arbitrage. currently there are many different online exchanges where
Bitcoin can be bought and sold. Although this is common what is weird is that
the different exchanges don’t always have the same price (Beigel). The website
Crypto compare, cited bellow, tracks the price of Bitcoin among several different
exchanges and updates in real time. As table #1 shows these prices are not all
equal. As of the time of writing the biggest difference among the big
exchanges, is between GDAX at where Bitcoin is at 17,233$ and Hit BTC where it
is at 16,661.12. At first glance this seams like arbitrage at its finest buy a
Bitcoin on Hit BTC at 16,661.12, and immediately after sell it for 17,233$ on
GDAX and make 571.88$ or 3.43% return instantaneously. Because Bitcoin can be
bough at any fraction investors could theoretically scale this to any Dollar
amount desired. However there is one big problem with this process. The way
Bitcoin transactions work is through the block chain the transfer of Bitcoin is
not instantaneous it can take 10-20 minutes for the transfers to be authorized
and happen (Beigel). This is a big issue because of Bitcoin highs volatility.
The fact that Bitcoin is 17,233 on GDAX at the time you buy it on Hit BTC does
not mean that it will be the same by the time you have transferred the Bitcoin
and are ready to sell it. This adds a degree of risk, which means that it is
not real arbitrage since by definition arbitrage is a risk free investment.


Explanation for

            Financial theory expresses that
there is a principal of no arbitrage because as previously explained the market
should auto correct itself when arbitrage arises. So why are there 2 different
arbitrage opportunities with Bitcoin. The most likely answer is that the market
as of right now is simply not efficient, this is most likely due to the fact
that it is a very new market and a comparatively small one and over time if
Bitcoin in fact continues to exist the market will evolve into an efficient one
but it might take some time and in the meanwhile investors should exploit the
arbitrage opportunities.



            Is Bitcoin a bubble? Maybe but it is also undeniable
that it has some sort of underlying value to it, even if intrinsically it has
no value. Gold has been a centerpiece of society for thousands of years,
without having any intrinsic value, and there is no reason Bitcoin could not be
the futures version of gold. Investors should watch Bitcoin closely and further
assess if it is a bubble or here to stay, and in the mean time they should
attempt to take advantage of the arbitrage opportunities it has brought along.