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The Economist Investment Case Study Competition 2016

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The Economist Investment Case Study Competition 2016 THE ECONOMIST INVESTMENT CASE STUDY COMPETITION 2016 Vs. Team: Scarlet Knights Michael Friedlander (Class of 2018) Viral Kagrana (Class of 2018) Noriko Kawashima (Class of 2018) Table of Contents PAGE I. Abstract……………………………………………………… 3 II. Crypto-Currencies: An Overview…………………………… 3 III. Current Macroeconomic Landscape………………………… 5 IV. Macroeconomic Outlook…………………………………… 6 V. Investment Thesis…………………………………………… 8 VI. Risk Factors Affecting Price Movement…………………… 9 VII. Our Model…………………………………………………… 11 VIII. Final Thoughts……………………………………………… 12 IX. Appendix I: General Bitcoin vs. Ether Comparison………… 14 X. Appendix II: Uses for Ether………………………………… 15 XI. Appendix III: Liquidity Trap Explanation………………… 16 XII. Appendix IV: Regression Analysis………………………… 17 XIII. Appendix V: Portfolio Data………………………………… 19 XIV. Resources Used…………………………………………… 20 Page 2 of 26 I. Abstract Crypto-currencies are decentralized, digital currencies that are created by individuals, and used to trade goods and are available for purchase through online exchanges. The crypto- currency market has grown to over 12 billion dollars. We analyzed the investment risks and historical prices of two biggest players, Bitcoin and Ethererum, to derive a recommended portfolio mix of the securities over a 5-year investment horizon. One optimal portfolio mix was first identified based on Sharpe ratio created from historical return and volatility. This mix was further adjusted to reflect our view that Ethereum was comparatively less risky than Bitcoin due to its lack of geographical concentration and potential practical uses, limiting the downside in the event of currency value decline. Our final recommendation is 80% in Ether and 20% in Bitcoin for an estimated return of 26.67%. II. Crypto-Currencies: An Overview Historically, two distinct types of currency, namely, commodity and fiat, have driven the growth of nations. Commodity currencies, like gold silver and salt, are currencies whose value is derived from a physical commodity and have uses beside trade. Fiat currency is currency established by governmental decree. Today, they are backed by the full faith and credit of their issuer. They are pieces of paper with little intrinsic values; people’s faith in the issuer and belief in the value of the currency create a trust in the system. Another type of currency, virtual currency, is commonly seen in video games, and is used as a medium of exchange in the games they were created for. Their value only exists inside these specific spaces. Page 3 of 26 In 2009, the appearance of Bitcoin (as a technology, Bitcoin, as a currency, BTC) changed that, as it brought virtual currency to the real world. This development established the first major crypto-currency, a unique type of digital currency commonly called Coins. To create new coins, individuals, called miners, use raw computing power to solve increasingly difficult cryptographic puzzles, called blocks, in order to gain currency. Every new block created awards BTC. The price of computer hardware and increasing difficulty of the puzzles influence mining activities and production rate. Created Coins are stored in digital wallets. These wallets have a unique public and private signature that are used to confirm transactions. Though not widespread at this point, crypto-currency has grown in size and scope since 2009 with two key Coins – BTC and Ethereum – taking center stage. In October 2008, Satoshi Nakamoto, a nom-de-plume for its developer(s), released a white paper outlining Bitcoin. It would be a decentralized currency built on trust and independent of governmental oversight. This trust would be gained by using a distributed public ledger, called a blockchain. The idea is that mined Coins and transactions made are recorded in a blockchain. Any new line added to the ledger is checked against the blockchain to make sure that there is no double-spending of coins and fits into preexisting blocks. The blockchain is decentralized and public in order make it harder to corrupt and create trust in the community. To avoid inflation in the long run, the total BTC are capped at 21MM; more than 15MM are in circulation. The reward for solving each block is halved every four years, decreasing the rate of change in supply. Bitcoins are used as a store of value, much like gold, or as means of buying and selling goods online. Although retailers are beginning to accept BTC, it has not surpassed traditional money as the primary means of payment. BTC is often compared to gold by the media because Page 4 of 26 of its ability to supposedly store wealth. Historically, gold has been considered one of the most trusted forms of exchange and means of storing wealth. Because its price movements do not correlate to any other asset, people believe it is resistant to market movements. Ethereum was developed by Vitalik Buterin in 2013, publishing a white paper with the specifications and rationale behind it. After two years of development and testing, the Ethereum platform was launched in July, 2015. Ether, the actual currency, was created as alternative, transaction driven crypto-currency based on the same underlying concepts of the blockchain, or DAO for Ethereum, and mining that power Bitcoin. Ether does not have a hard cap for total ether production. A maximum of 18MM Ether can be mined per year. In addition to Ether’s core code, a programing language, Solidarity, was developed alongside to allow users to write smart contracts. Smart contracts are code driven contracts that can be enforced. Companies such as Deloitte, IBM and Microsoft are all developing uses for Ether because of this feature. More importantly, the R3 Consortium, a collection of more than 40 financial institutions including JPMorgan, and Goldman Sachs, are looking at ways to use Ether for financial use. We believe that Ethereum is most like silver given its potential to have practical uses. III. Current Macroeconomic Landscape In 2007, the subprime lending market began to collapse. In March 2008, the Fed organized a bailout of Bear Stearns due to their subprime exposure. In September 2008, as a result of their subprime exposure and unable to secure a bailout, Lehman Brothers declared bankruptcy causing the financial system to collapse. In response to this exogenous shock, the Fed began its bond buyback program, quantitative easing (QE). QE acted as cash infusion meant to Page 5 of 26 jumpstart the economy. The Fed purchased troubled debt assets in exchange for cash, lowering interest rates. Conventional economic wisdom expected this to stimulate business investments and lead to inflation. The Fed’s QE program and near zero percent interest rate failed to stimulate growth and added excess liquidity instead. The excess liquidity is trapped in bank’s balance sheets waiting to be unleashed. The only way the Fed can reign this trapped liquidity in is by raising interest rates. If not carefully accounted for, this excess liquidity can cause a high rate of inflation or lead to the formation of Speculative Asset Price (SAP) bubbles. SAP bubbles refer to the valuation of assets at prices that are significantly above their intrinsic value. SAPs have been believed to result from excess liquidity and may develop a specific asset classes or sectors without corresponding inflation in the overall economy. Recent examples of SAP bubbles are the dotcom and housing bubbles. One of the biggest responses to instability and SAP bubbles is a flight-to-safety. Certain countries, such as the US and Switzerland, are viewed as safe havens because they have the ability to weather economic downturns. As a result, a flight-to-safety is when investors move their money from risky assets into stable, risk averse, government bonds in safe haven countries. There have been multiple flights-to-safety over the last 8 years, including during the 2008 recession, the 2012 Greek crisis, and, most recently, Brexit. These events saw investors move money into government bonds because they are safe, trustworthy investments. Many early crypto-currency adopters treat Coins the same way. They view Coins to be just as safe as sovereign debt and a viable safe haven. IV. Macroeconomic Outlook Page 6 of 26 Based on our research, over the next five years we expect interest rates to increase, increasing from 0.5% to over 3% by 2019. We expect inflation to rise as well, reaching 2% by 2018. QE has put the Fed and ECB in a corner. Any increase in interest rates will increase the probability of another global recession and instability in the US and Europe while reducing excess liquidity in the market. Any increase in interest rates will lead to a market sell-off and reduce both investor and consumer confidence as a result. Likewise, the news about Deutsche Bank’s current financial position concerns us, as its failure will force investors into safe haven. We believe that there is a high probability for either a major market selloff or the failure of a financial institution will cause an investor panic. We cannot discount the results of the November’s Presidential election as well. Regardless of the outcome, we expect there to be more global instability. As a result, we expect a significant flight to safety at the first signs of a crisis and the dollar to strengthen Our viewpoint extends into Coins. We believe that crypto-currency is unsound because it has not developed the same level of trust as traditional currencies. Although the blockchain concept works in theory, we are concerned that technological issues such as the undocumented bugs that caused July’s DAO Hack, disputes over how to improve and implement the underlying system code, and the security of online exchanges and vendors, will reduce consumer confidence in crypto-currency could cause significant instability in the marketplace. In particular, the lack of standardization for updates to Bitcoin and Ethereum’s platforms, makes investment in either currency a risky proposition.
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