Market risk and Bitcoin returns
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Market risk and Bitcoin returns Dimitrios Koutmos1 © Springer Science+Business Media, LLC, part of Springer Nature 2019
Abstract Bitcoin is emerging as a distinct asset class among investors given its seemingly detached price behavior relative to market and economic fundamentals. Its incomparably high returns in recent years has further fuelled intense interest and investment into Bitcoin and cryptocurrencies at large. This paper cautions that Bitcoin prices, despite their seemingly attractive independent behavior relative to economic variables, may still be exposed to the same types of market risks which afflict the performance of conventional financial assets. Using a Markov regime-switching model to distinguish between regimes of high and low Bitcoin price volatility, this paper shows that while returns on the aggregate market portfolio cannot explain Bitcoin returns, other asset pricing risk factors, such as interest rates and implied stock market and foreign exchange market volatilities, are important determinants of Bitcoin returns. Distinguishing between periods of high and low Bitcoin price volatility reveals heterogeneity in the explanatory power of market risk factors; in particular, Bitcoin returns are more difficult to explain during periods of high volatility relative to periods with low volatility. This finding can partially explain why extant studies, which neglect to distinguish between exchange rate regimes in Bitcoin, have difficulty linking Bitcoin prices to economic fundamentals. Keywords Asset pricing · Bitcoin · Markov switching model · Risk-return tradeoff JEL Classification G12 · G17 · G23
1 Introduction Blockchain technologies and cryptocurrencies are receiving much attention and, in recent years, have become a source of controversy among investors, speculators, economists and regulators alike. On the one hand, this flourishing new technology is gaining momentum in our global economy because it facilitates cross-border commerce and financing activity whilst also serving as a competing alternative to international fiat currency systems (Bouri et al. 2017; Li and Wang 2017; Maurer et al. 2013). On the other hand, regulators fret over the possibility that cryptocurrencies can be used to fund illegal activity (Grinberg 2012). Economists, who seek to delineate the price behavior of cryptocurrencies and understand
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Dimitrios Koutmos [email protected] Worcester Polytechnic Institute, 100 Institute Road, Worcester, MA 01609, USA
123
Annals of Operations Research
their intrinsic value, argue that such digital currencies exhibit prices that are too volatile to serve as a store of value, unit of account or medium of exchange and that such volatility cannot reasonably be explained by economic fundamentals (Ciaian et al. 2016; Lo and Wang 2014; Pieters and Vivanco 2017).1 To date, there are approximately 1142 cryptocurrencies in existence with a total market capitalization of over 146 billion USD (CoinMarketCap 2017). Presently, Bitcoin is the most popular cryptocurrency and the most liquid. I
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