Investing with Cryptocurrencies - A Liquidity Constrained Investment Approach

Cryptocurrencies have left the dark side of the finance universe and become an object of study for asset and portfolio management. Since they have a low liquidity compared to traditional assets, one needs to take into account liquidity issues when adding them to the same portfolio. We propose a LIquidity Bounded Risk-return Optimization (LIBRO) approach, which is a combination of risk-return portfolio optimization under liquidity constraints. In the application cryptocurrencies are included into portfolios formed with S&P 100 component stocks, US-Bonds and Commodities. We illustrate the importance of the liquidity constraints in an in-sample and out-of-sample study. LIBRO improves the weight optimization in the sense of adding cryptocurrencies only in tradable amounts depending on the intended investment amount. The return increases strongly in-sample and out-of-sample. The paper shows that including cryptocurrencies can indeed improve the risk-return trade-off of the portfolio