Testing the Local Martingale Theory of Bubbles using Cryptocurrencies

Abstract

Cryptocurrencies provide the ideal and natural experimental setting to test the local martingale theory of bubbles, because they have no cash flows. Using this theory, we test for the existence of price bubbles in eight cryptocurrencies from January 1, 2019 to July 17, 2019. The cryptocurrencies are Bitcoin (BTC), Litecoin (LTC), Ethereum (ETH), Ripple (XRP), Bitcoin Cash (BCH), EOS (EOS), Monero (XMR), and Zcash (ZEC). A novel, simple, and robust testing methodology is created to facilitate this estimation. During this time frame, five of the eight currencies (BTC, BCH, EOS, XMR, ZEC) exhibit price bubbles, Litecoin does not, and the evidence for Ethereum and Ripple is inconclusive. The paper provides strong evidence for the prevalence of bubbles in cryptocurrencies and supports the feasibility of applying the local martingale theory of bubbles to various asset classes.

Keywords: Price Bubbles, Arbitrage Pricing Theory, Martingale, Cryptocurrency

JEL Classification: G12, G13, G14, G17, G18