Mispricing and Risk Compensation in Cryptocurrency Returns

Abstract We examine the role of systematic mispricing and risk compensation in explaining cryptocurrency returns using instrumented principal component analysis. We demonstrate that both elements make meaningful contributions to the variation in returns through distinct economic mechanisms. Mispricing primarily operates through behavioral channels, capturing speculative demand and liquidity frictions. A pure-alpha strategy delivers large and significant Sharpe ratios, confirming the economic importance of mispricing. Risk compensation is driven by fundamental factors, including past performance and exposures to both cryptocurrency and equity market risk. Consistent with this equity exposure, we document increasing correlation between cryptocurrency and equity returns over time.