Trying to understand Bitcoin value

Bitcoin, a decentralized digital resource, soared to astronomical levels in the latter part of the last decade. Bitcoin is built on the blockchain concept and the emergence of blockchain technology, a groundbreaking phenomenon. The blockchain is a public ledger that records all the transactions and is implemented as a blockchain, where each block contains a cryptographic hash of the previous block.

The applications of blockchain in the financial domain are truly innovative and have been widely used in cryptocurrency mining. There are thousands of cryptocurrencies, but Bitcoin is the most famous. In 2011, the price of one Bitcoin was around $0.30 and it took several years to catch the attention of the investing fraternity. It was around $998 in 2017 and reached a peak of $19,783 in December 2017. Bitcoin continued to fluctuate and it is interesting to note how volatile the crypto markets (including Bitcoin) have been recently.

In this article, we try to investigate whether there is a method to the madness. The idea is to investigate whether Bitcoin prices can be captured using one of the valuation methods proposed by the industry players/academics. There are several valuation approaches, but we stick to the one proposed by Adam Hayes.

The argument for this model is that even though Bitcoin is an intangible asset, it has intrinsic value and has similar characteristics to mining. The model relies on the concept of marginal production costs, which means that Bitcoin prices should not deviate from marginal cost. In other words, Bitcoin production can be visualized as a competitive market, and thus the miners are expected to mine to a point where the marginal cost is equal to the marginal price.

Essentially, the model argues that the Bitcoin price is a function of the following: (a) hash power; (b) energy efficiency; (c) energy costs; (d) relative difficulty (difficulty of mining algorithms), and (e) block reward

Based on the work of Hayes (2019), the assumed dollar cost of energy is $0.135 per kWh. The estimated average energy efficiency in the period 2014 to 2021 is 0.09 J/GH. When Bitcoin was first launched, each block had a reward of 50 Bitcoins mined. This reward was halved every four years and based on that the current block reward is $6.25.

The degree of difficulty is taken from www.blockchain.com/ charts#mining. The difficulty level only changes every two weeks, so we only use data from those dates. Using the above model, we try to predict the value of Bitcoin and then compare it to the actual observed price. The time period for this study is 1 January 2021 to 31 December 2021.

Predicted price from the model is compared with actual observed price. The results are plotted in the figure and it can be observed that the observed price does not deviate much from the predicted price.

Trying to understand Bitcoin value

Historically, it has been observed that it has been extremely difficult to value a new financial asset. For example, the valuation of dotcom companies in 2000 was quite difficult as the business model was completely new compared to the then existing business models. Similarly, cryptocurrencies, non-fungible tokens (NFT), etc., have caught the attention of investors and the financial market will take some time to value these new financial assets.

Azmi and Subramanian are on the faculty of the Thiagarajar School of Management. Views expressed are personal

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