A Prospect Theory Model for Predicting Cryptocurrency Returns

25 Pages Posted: 2 Feb 2021

See all articles by Alexander Thoma

Alexander Thoma

University of Zurich - Department of Banking and Finance

Date Written: December 08, 2020

Abstract

This paper investigates the risk and return properties of a trading strategy for the cryptocurrency market. The main predictive power for portfolio formation comes from a simple prospect theory model that only uses price information readily available. The dataset consists of a large body of cryptocurrencies from 2014 to 2020. I find a strong outperformance over the market, even after controlling for known predictors. Factor regressions with a cryptocurrency three-factor model further reveal significant alphas. Robustness test emphasize the legitimacy of the strategy. On average, cryptocurrencies with a high (low) prospect theory value earn low (high) subsequent returns. Interestingly, traders in the cryptocurrency market seem to assess the attractiveness of cryptocurrency in a way described by prospect theory. Mechanical tests of the model show that probability weighting is a main driver behind this assessment. Cryptocurrencies with a high prospect theory value tend to be highly positively skewed. This skewness could be the reason why the cryptocurrency seems attractive to traders, similar to lottery-like gambles.

Keywords: Asset Pricing, Behavioral Finance, Cryptocurrencies, Cryptocurrency Markets, Cryptocurrency Trading, Herd Behavior, Loss Aversion, Portfolio, Portfolio Choice, Prospect Theory

JEL Classification: G10, G11, G13, G40, G41

Suggested Citation

Thoma, Alexander, A Prospect Theory Model for Predicting Cryptocurrency Returns (December 08, 2020). Available at SSRN: https://ssrn.com/abstract=3753530 or http://dx.doi.org/10.2139/ssrn.3753530

Alexander Thoma (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Sch├Ânberggasse 1
Z├╝rich, 8001
Switzerland

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
87
Abstract Views
260
rank
343,848
PlumX Metrics