How to Price Cryptocurrency (Bitcoin) Derivatives?

Bitcoin (BTC) broke through to a record high of $11,831 over the weekend as volatility in the cryptocurrency continues to rise. Amidst these large and recent price fluctuations, the CME Group (Chicago Mercantile Exchange & Chicago Board of Trade) announced that its new bitcoin futures contract will be available for trading on December 18, 2017. While the valuation of traditional currency and equity derivatives is well established among professionals working in the financial industry, the introduction of the first cryptocurrency bitcoin derivative poses valuation questions as it relates to a new pricing model. Simply put, how are cryptocurrency derivatives priced?

Financial engineering is a continuously evolving discipline designed to introduce and test new products, pricing models and hypotheses. Currently, equity futures are typically priced using variables such and the risk free interest rate and dividends, and currency forwards are priced based on the foreign and domestic interest rate differential between the two currencies in the pair. Additionally, equity options are typically priced using the Black–Scholes option pricing model, and currency options are priced using the Garman–Kohlhagen option pricing model. All of these equations take into account variables such as dividends and/or interest rates.

However, bitcoin as an asset class does not pay dividends nor is it tied to a specific risk free, domestic or foreign interest rate. As a result, a new or modified version of a derivative pricing model for cryptocurrency that accounts for the unique nature of this new digital asset class will likely be used to value the first bitcoin futures contracts. Many academics and practitioners are sharing their thoughts on the best approach for pricing bitcoin derivatives. A couple of commonly raised questions include: (1) How are dividends removed from the traditional pricing models? and (2) What interest rate(s) should be used? As the financial industry navigates a new frontier with cryptocurrency and blockchain technology, how do you think bitcoin derivatives should be priced?

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Comparing Cryptocurrency to Foreign Currency

Cryptocurrencies such as Bitcoin have captured headlines in 2017, and the question of how modern cryptocurrencies compare to traditional foreign currencies is often raised. FX Initiative helps global businesses manage foreign exchange (FX) risk, and this article will explore some of the key differences between cryptocurrency and foreign currency from a corporate foreign exchange risk management perspective.

It is clear that cryptocurrencies are still in their infancy, but the debate in the financial community over the future growth of this digital asset class remains open. While many articles have focused on areas such as monetary authorities, regulation, costs, timing, and transparency, this article will offer a unique focus specifically on the areas of acceptance, exchange, utilization, obsolescence, and risk management.

Acceptance
A small but growing number of brand name companies promote their acceptance of Bitcoin, such as Overstock.com, DISH Network, Expedia, Microsoft, and others. In fact, Coinbase claims that 47,000 businesses integrate Bitcoin with their service. However, companies such as Dell and Fiverr announced their acceptance of Bitcoin in 2014 but have since updated their policies to no longer accept Bitcoin. As it stands today, cryptocurrency, unlike foreign currency, is not a universally acceptable medium of exchange for procuring goods and services.

Exchange
It is important to note that most major corporations who accept cryptocurrency are partnered with digital asset intermediaries such as BitPay and Coinbase to instantly exchange Bitcoin for fiat money such as U.S. dollars or euros. By doing so, the companies minimize their holding period and financial exposure to the heightened volatility of a cryptocurrency. Unlike foreign currency, which is not always immediately exchanged, a company’s acceptance of cryptocurrency largely depends on their partnership with intermediaries to transfer the financial risk immediately.

Utilization
While Bitcoin is increasingly used by investors and consumers, businesses still lack widespread utility for the cryptocurrency. For example, when a company earns foreign currency denominated revenue, they may also have foreign currency denominated expenses (i.e. payroll, suppliers, vendors, cost of goods, etc.), which creates a natural utility for the foreign currency. In contrast, most corporations that earn Bitcoin denominated revenue lack Bitcoin denominated expenses, which reduces the utility of the cryptocurrency for funding ongoing business operations.

Obsolescence
Although Bitcoin is perhaps the most well known cryptocurrency, there were over 200 initial coin offerings (ICO) in 2017, which collectively raised more than $3.2 billion. The following white papers on Bitcoin, Ethereum, Zcash, Monero, Bancor, Tezos, and EOS explain the pros and cons of each project, and there remains a high degree of uncertainty as to which cryptocurrency will emerge as the long term market leader. Unlike foreign currency, specific cryptocurrencies have the potential to become obsolete as newer and better technology evolves over time.

Risk Management
The Consumer Financial Protection Bureau (CFPB) warned about the potential issues with virtual currencies such as unclear costs, volatile exchange rates, the threat of hacking and scams, and companies not offering help or refunds for lost or stolen funds. Additionally, the most viable current means of managing Bitcoin's financial risk is simply transferring ownership though intermediaries. If and when firms such as the Chicago Board Options Exchange launch bitcoin derivatives trading products, foreign currencies have superior risk management products & services.

Overall, foreign currencies are widely accepted, easily exchanged, naturally utilized, lack obsolescence, and offer a range of risk management tools to mitigate risk such as over the counter (OTC) and exchange traded derivatives including forwards, swaps, options and futures. As we approach the 10 year anniversary of Bitcoin’s introduction, the adaptation of cryptocurrency in the business world will continue to be notable and newsworthy. Join the ongoing discussion and share your comments and stories on cryptocurrency and its impact on business.

FX Initiative is collaborating with cryptocurrency experts to help educate the business community. We’re creating compelling content and interactive risk modeling tools for simulating Bitcoin denominated transactions, hypothetical hedging instruments, and policies and procedures to facilitate a wider understanding of the practical application and potential of cryptocurrency. To learn more about foreign exchange risk management or to participate in our cryptocurrency collaborations, contact us here, email support@fxinitiative.com or visit FX Initiative at https://fxcpe.com.