As the topic title mentions, this one is to Finance gurus, I expect users who would answer my question to have some advanced understanding about the different methods used to price an asset (i.e. stocks).

So as you know guys in valuing the intrinsic value of an asset to a diversified individual investor, one element used in the CAPM model, is the stock's beta and the market's risk premium, which together capture the risk of a certain asset. And risk in finance is described as the standard deviation between actual vs. expected return, or in other words, how much a certain stock's return deviates from its expected return (the more it deviates the more risky an asset is perceived to be).

But isn't this illogical? why would stock A, which deviates more than stock B (both having the same expected return) be priced in such a way as to generate higher returns?

To put you in the same state of mind as me, think of the following:

Suppose that I am about to sell two different tickets, one that entitles its bearer to earn 1$ every time I toss a coin for 10 consecutive tosses no matter the outcome (whether heads or tails), and the other 2$ every time the outcome is heads but nothing for tails. And so I put these two tickets in the open market so that investors can bid on them.

In finance, the latter is a more risky investment and thus current finance theory suggests that the market would price it at a lower price point than the former, being “Risk free”. But if this was the case, then everyone would rush to buy the latter ticket, after all, why would the ticket with a certain payoff be priced more expensively than that of an uncertain one if they both have the same expected return? (especially to a diversified investor)

Notice that both have an expected return of 10$, and so my theory says that eventually, they will be both priced in the market at the same price point (a little less than 10$ per ticket).

This is all to suggest that risk in finance should be measured in a different way, what do you guys think?

[Now I can think of 4 possibilities:]

For those who had Bitcoins right before the Chinese Government's announcement this week and didn't sell them right after the announcement, why didn't you? I'm just curious.

Now I can think of 4 possibilities:

1- You thought the price will go back up and so got hold of your Bitcoins --> Very bad decision
2- You couldn't sell them due to the lack of buyers --> Plausible but unlikely
3- You are emotionally attached to your Bitcoins so you don't want to lose them no matter what --> You need a psychologist
4- When you found out about it, it was already too late --> I forgive you

(More reasons are welcome)

Now here's the explanation for the comments I included right after each possibility.

For reason # 1:

This would be a bad decision if you believe the money you could have made by selling high and buying back at a lower price is greater than the transaction costs associated with these two transactions. Let's say for example that transaction costs for trading Bitcoins is at 1% the value of your total transaction; in this case if you sold at 1,200$ which is nearly the value of each Bitcoin at the time of the news and bought back towards 700$, the value at which a Bitcoin became more stable, you would have made = [(500$ - transaction costs) x (the number of Bitcoins traded)], out of thin air.

The only counter-argument to this analysis would be to convince me that it wasn't normal (according to market dynamics) for a Bitcoin to fall for more than 2- 3% after the news (the break-even point at which you would have been indifferent to sell or hold your Bitcoins).

For reason # 2:

This is a plausible reason, and one which I wouldn't argue to much, except for the fact that I believe we have liquid markets for Bitcoins nowadays, and it's always possible to find a sucker who's willing to pay a higher price than market perception for a Bitcoin. Please correct me if I'm wrong.

For reason # 3 & 4:

No comment

[How can a virtual currency traded over the internet not be a global currency you might ask? keep on reading...]

How can a virtual currency traded over the internet not be a global currency you might ask? keep on reading...

If we look at how Bitcoins have been created over the past couple of years, it will not be long before we notice that it logically entails that the currency today will be concentrated in certain geographical areas in the world. To see how this is so, think about the dynamics and the rules of how Bitcoins are created:

- Bitcoins are mined by users having a certain type of hardware
- Total Bitcoins mined on a daily basis decrease in a increasing fashion (i.e. total Bitcoins mined today will be more than the ones mined tomorrow)
- The more users mine Bitcoins, the less share each of those users will get
- As time progresses, it becomes more difficult to mine each unit of Bitcoin, as the codes to solve becomes more difficult

Following those rules, it then becomes logical to notice that since Bitcoin spreads faster in the earlier days of its creation, the geographical areas where Bitcoin miners emerged (where Bitcoin started to spread), are the areas with the largest concentration of Bitcoins; not only that, but it's now extremely difficult to get those Bitcoins out of those areas, here's why:

1- For Bitcoin to become widely used in a given geographical area there first must be an abundance of Bitcoins in that area; that is, a sufficient supply of Bitcoin in that area. Since it is now much more difficult for a user to mine a "new" Bitcoin, it is unlikely that supply will take off in currently virgin areas. This in return creates a supply problem (i.e. no enough users having Bitcoins in certain geographical area).

 2- The lack of sufficient supply of Bitcoins in a certain area, will create a demand problem of Bitcoins as well, since the whole ecosystem in that given area will either not be familiar with Bitcoin as a traded currency, or will not be willing to take the risk and start accepting Bitcoins as a means of payment in fear of getting stuck with those Bitcoins and not being able pay with it in return.

This is the network effect at play. To give you another example portraying the same effects think about the following:

If you were to acquire the first telephone in the world, how much would you be willing to pay for it? not much, since it will be nearly worthless (you cannot call anyone with it), but the more telephones in circulation, the more desirable a telephone will become. The reason why Bitcoin first took off in certain areas is because they were easily and freely (nearly freely) distributed (mined). This is like giving out telephones for free. But once Bitcoins started to become more and more available and popular, people started to become more willing to pay for them, since they started acquiring more value (Like paying for a telephone after it became more widely available). Problem is, this network effect is only present in certain geographical areas and not in others, and since now one has to pay a large amount of money to acquire a "New" Bitcoin, it is only worth acquiring it in those areas where it already has value (Network effect value that is).

So what are the implications of that?

It simply implies that Bitcoin is not as global a currency as you might think! It will remain in certain geographical areas (At least in the short to medium term). Try to spend a Bitcoin in the US and it will be a relatively easy task, but try to spend it in the Middle East, and I will wish you good luck with that.....


How can this problem get solved?

Well the only solution I can think of is to make it cheaper for people in virgin areas to acquire Bitcoins, and progressively make it more and more difficult as time goes by as they catch up with the areas having an abundance of Bitcoins. This can be done in 3 different ways:

1- Make it easier to mine Bitcoins in Virgin areas.

2- Create a new currency in Virgin areas that undergoes the same evolution as Bitcoins, and make those different currencies exchangeable at a certain rate

3- Create a flow of Bitcoin donations to users in virgin areas. Not only will this introduce Bitcoins to new areas, but it will in return strengthen the value of Bitcoins worldwide. The more traded Bitcoin becomes, the higher it will go in value and so the net effect will probably become an increase in the total Market Cap of Bitcoins, enough to get back in value what is donated.

Hope this makes sense