Bitcoin, EUR/USD, crude oil and S&P 500 as “volatile”?

Naked markets

The prices of cryptocurrencies, including Bitcoin (BTC), have historically fluctuated wildly. However, financial institutions have gradually started to treat them as an important asset class and an alternative to stocks, bonds or the commodity market. The question naturally arises: are cryptocurrencies unique in terms of momentum, volatility and predictability? This question is answered by a research paper by Young Li of Bloomberg Enterprise Quants, which was published in late 2021.

Why should cryptocurrencies be an exception to the rest of the market?

Cryptocurrency prices are generally considered volatile. In 2016 the price of Bitcoin increased by 125%, and in 2017 by more than 2000%. After reaching its peak in 2017, it has fallen by more than 80%. After the government and central bank of China announced a ban on all cryptocurrency transactions or facilitations, it more than halved in August 2021 to around $29,700 as miners sought to relocate their operations . Why are cryptocurrencies so volatile?

Apart from government regulation, the dominant factor is the traditional demand and supply mechanism: by design, Bitcoin is limited to 21 million coins – the closer the circulating supply gets to this limit, the more likely prices are to fall. ‘increase. But it is difficult to predict what will happen to the prices when the limit is reached.

On the other hand, cryptocurrencies are still a new instrument and remain in the “price discovery” phase while their “end values” are still undetermined. Cryptocurrencies are gradually being adopted by financial institutions as a new asset class. According to the 2021 Global Cryptocurrency Hedge Funds Annual Report compiled by PwC, the total assets under management (AuM) of cryptocurrency hedge funds worldwide rose to nearly $3.8 billion in 2020. 2020, compared to $2 billion the previous year.

There are well-known models that describe the dynamics of volatility and are used for forecasting, such as ARCH (Engle 1982), GARCH (Bollerslev 1986), HAR (Corsi 2009), etc. The natural question arises: is a cryptocurrency like Bitcoin unique or unique in terms of against the dynamics of volatility and predictability?

In order to answer this question, Bloomberg used a variety of comparative instruments. The table below lists the instruments under consideration, grouped by category. The evolution of variability over time is complex, but the abundant literature on the subject reveals two commonly known properties: persistence and reversion to the mean.

List of instruments compared in a study assessing the predictability of cryptocurrency volatility.  Source: Bloomberg
List of instruments compared in a study assessing the predictability of cryptocurrency volatility. Source: Bloomberg

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Bitcoin and cryptocurrencies are not much different from the rest of the assets

In a study titled “The Predictability of Cryptocurrency Volatility”, the author proves that the difference in predicting the volatility of Bitcoin, S&P 500, Crude Oil or EUR/USD is practically imperceptible. Especially in recent years when the digital asset market has matured a lot.

– I show that both from the point of view of sustainability and reversal of average volatility, cryptocurrencies are similar to instruments of other asset classes (…) The performance of the models is evaluated using the correlation coefficient between observed and predicted volatility. In both cases, the correlation decreases with the increase of the prediction horizon – was written in the introduction to the study.

Based on the correlation curves and the forecast horizon, the Bloomberg analyst concludes that the cryptocurrency asset class behaves similarly to other markets, including, among others, market assets actions. At the same time, it indicates that the volatility of cryptocurrencies is on average as predictable as for other instruments. Over time, as this market matures, they get closer to each other.

If you are interested in detailed calculations, models and graphs, check out the full content of the study.

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