Crypto’s volatility premium

That is the topic of this week’s Bloomberg column, 2x the usual length, building on earlier work by Tyrone, see also this Megan McArdle column.  As for me, here is a key excerpt:

Much of the primary value of crypto assets is from their price volatility, which is part of their appeal. I raised this possibility some while ago, tongue in cheek, but upon further reflection it seems to me an actually useful (albeit counterintuitive) way of thinking about crypto assets. The general idea of price volatility as a value dates at least as far back as Fischer Black, one of the founders of options price theory.

In standard economic theory, investors are risk-averse, meaning they prefer more stable consumption patterns to less stable ones. That is usually true, but it does not mean investors always prefer more stable investment prices — a crucial distinction.

Consider this hypothetical: You are given an envelope containing one dollar. You are then offered the opportunity to exchange it for an envelope which contains either twice the money (that is, $2) or half the money (50 cents), each with 50% probability. In essence, you are accepting some exchange-rate volatility.

Most people will find this bet a pretty good one. The new expected value of your envelope is (0.5 x $2) + (0.5 x $0.5), or $1.25. That is a higher expected value than your original dollar.

If you are perched at the margin of subsistence, this bet might seem too risky. But for most investors, who have some level of wealth, it is an improvement in prospects, though with some additional risk.

Bitcoin and other crypto assets are essentially offering you a form of this bet. To be sure, this 50-50 bet does not exactly describe the price dynamics of crypto assets. But it is one way of illustrating that crypto prices, relative to the dollar, will either go up a lot or down a lot. The bet helps show that some investors might welcome price volatility — or, if you wish, call it exchange-rate volatility. And with even wilder swings in value, there is more extreme price volatility, which can be even more appealing.

So when Bitcoin and other crypto assets come along, they are a new source of expected gain — precisely due to their price volatility. It is like being invited into a casino where the odds favor you rather than the house! You won’t always win, but a lot of people will want to keep playing.

I’ve been pondering that argument since 2013, maybe now is the time to simply accept it.. Fischer Black and Jensen’s Inequality!