Prediction markets help investors hedge bitcoin volatility risks

Public Opinion as an Option: Leveraging Prediction Markets to Hedge Exposure to Spot Crypto Volatility

Computational Engineering, Finance, and Science

Summary

Investing in cryptocurrencies like Bitcoin can be risky because their prices go up and down a lot. The paper shows how people can use special markets called Kalshi Crypto Event Contracts as a kind of financial tool similar to options to protect themselves against these price swings. By creating different portfolios that include these contracts, investors can reduce risk without giving up on potential gains from Bitcoin. The authors tested their approach in different market situations, like when prices go up, down, or stay steady, and found it works better than simple strategies. They also mention that fees might reduce profits and suggest areas for future study.

What this means in practice

  • For retail crypto investors: Manage bitcoin price risks by combining spot holdings with Kalshi event contracts for more effective hedging strategies.
  • For financial advisors: Design client portfolios that incorporate prediction market contracts to balance exposure and reduce volatility risks in cryptocurrencies.

Tested on one dataset.

Authors

Prashanth Bhaskara, Aadit Jerfy

Abstract

This paper proposes an investment strategy through resource allocation into Kalshi Crypto Event Contracts in order to effectively hedge exposure to spot asset volatility. Using Bitcoin as a proof of concept, we treat corresponding Kalshi markets on the asset's future price as option contracts, and through construction of different portfolio allocations present a framework for which event contracts can be effectively utilized by retail investors in order to control risk framework without reducing underlying exposure to spot volatility. We showcase this information through analysis of three separate Kalshi event contracts, all relating to a different underlying market regime (i.e bullish, bearish, flat), and provide a comprehensive risk profile for each regime. Results show that a dynamic Kalshi/Bitcoin hedging strategy outperforms more simplistic portfolios across all regimes, supporting our initial hypothesis. We discuss further considerations which can erode profits in the future (i.e. fees), and provide direction for future research.
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