Bitcoin is not subjected to any market manipulation. This means that the insurers who will hold more bitcoins will have natural protection against inflation.
This also reduces the risk of the insurer investing in other assets and currencies, making it possible to get natural hedges against inflation and protect themselves against market volatility.
Rate of risk reduction in bitcoins
This article demonstrates how simple trading with bitcoin can reduce risk and potentially enable very high returns on investments through options, leveraged trading, and other sophisticated strategies. We focus specifically on options for two reasons:
(1) they are suited to reducing bitcoin’s above-average volatility,
(2) there is significant open interest in options trading on the two major exchanges, bitcoincircuit.cloud and OKCoin.
As the bitcoin value tends to go up as time goes by, assuming that there is no significant event that causes a sudden drop in the exchange rates of bitcoins, the insurance companies need to hold on to those bitcoins and not convert them into any other currency due to this factor.
Rate of risk mitigation in the USA
To understand the above factor in a better way, we can take an example of a hypothetical insurance plan with a $100 face value protecting against bitcoin’s risk over three years. The buyer of the insurance plans has to pay $20 in total, which includes $5 as an annual premium and $15 for the option premium.
If the underlying bitcoin price at maturity is $500, then the buyer of this plan has paid $20 in total and will receive a payout of $100, making him net profit by $80.
However, if the underlying bitcoin price at maturity is less than $500 (or more than $5000), he will lose money on this deal. He can also decide not to exercise the option if the underlying bitcoin price is somewhere between $300 to $400.
The previous example shows that an insurance company will only benefit from their decision to write this policy if at least one out of three possible scenarios are met, i.e., Bitcoin prices increase drastically over the next three years Bitcoin prices remain stable or Bitcoin prices drop significantly over the life of the option.
Hedging strategy
The previous example also shows that an investor can implement a hedging strategy to reduce his risk and maximize his returns. In this case, a simple hedge would have been to buy three bitcoins for each bitcoin, which will be insured against loss due to bitcoin’s price volatility.
This strategy would protect you from a price drop and give you significant returns if prices go up. However, to understand the effectiveness of such hedging, we need to understand the risk/return profile involved in each scenario:
Bitcoin value at maturity: $500
The insurance company will make a profit. You (the buyer) will make a profit, too, because you would have bought three bitcoins for every 1, which you insured against loss due to bitcoin’s price volatility.
The insurer and the buyer will both benefit from this hedging strategy, assuming that the bitcoin prices did not move beyond the threshold, in which case both would have lost.
The insurer can charge a higher premium than the $15, which they trust in this example because they will be hedging against most of their risk even before writing policies on bitcoins. The above is just one strategy that an investor can use to hedge his investments for bitcoin’s price volatility.
Bitcoin value at maturity: $1,000
The insurer will have to bear a loss of ($100 – $1,000)/$150 per bitcoin i.e., ($100/3 bitcoins = $33.33). You (the buyer) will also have to bear a loss of ($80 – $100). The insurer will not benefit, but the buyer will because he had hedged against bitcoin’s price volatility in this scenario. This hedging strategy will have protected you from a price drop and give you significant returns if prices go up.
Conclusion
- This would be considered a default scenario (no payout).
- You (the buyer) will make a loss of ($100 – $20)
- The insurer will also make a loss of ($100-(2*$15)), i.e., negative 4. Therefore, neither the buyer nor the insurer will benefit from this hedging strategy.
Story by Jean Nichols
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