Returns, Volatility and the Cryptocurrency Bubble of 2017-18

Abstract

Research on cryptocurrencies has focused on price and volatility formation in isolation, however knowledge about their interdependence is important for risk management and asset allocation. We investigate the existence and nature of such a relationship in four commonly traded cryptocurrencies: Bitcoin, Ethereum, Litecoin and Ripple, during the cryptocurrency bubble of 2017–18. Using a generalized asset pricing model, we find evidence of a risk premium effect in Litecoin and Ripple during the boom of 2017, and that adverse news effects were an important driver of the cryptocurrency crash of 2018 in all four cryptocurrencies. In an out-of-sample forecasting exercise, we find that allowing for stochastic volatility and a heavy tailed distribution provides more accurate return and volatility forecasts compared to a random walk benchmark. This suggests that cryptocurrency markets were not weak-form efficient during this period.