Evaluating the Role of Cryptocurrency Markets in Portfolio Diversification and Systemic Financial Risk Management

Posted: Jul 24, 2021

• Sarah Davis
• Sarah Harris
• Sarah Miller

Abstract

The emergence of cryptocurrency markets represents one of the most significant financial innovations of the past decade, creating new opportunities for portfolio diversification while simultaneously introducing novel forms of systemic risk to global financial systems. Traditional portfolio theory, rooted in Markowitz's mean-variance optimization framework, has proven inadequate for capturing the complex dynamics of cryptocurrency assets, which exhibit characteristics fundamentally different from traditional financial instruments. These digital assets demonstrate extreme volatility, non-normal return distributions, and correlation structures that evolve in ways not anticipated by classical financial models. The existing literature has largely approached cryptocurrency diversification from a conventional perspective, failing to account for the quantum-like entanglement phenomena that appear to characterize the relationships between digital and traditional assets during periods of market stress.