A risk-based explanation of cryptocurrency returns

69 Pages Posted: 5 Oct 2021 Last revised: 6 Mar 2024

See all articles by Daniele Bianchi

Daniele Bianchi

School of Economics and Finance, Queen Mary University of London

Mykola Babiak

Lancaster University Management School

Date Written: October 10, 2021

Abstract

We investigate the dynamics of returns in cryptocurrency markets through the lens of a small-scale latent factor model with time-varying factor loadings instrumented by individual cryptocurrency characteristics. We have three main empirical findings. First, our factor model excels in providing a risk-based explanation of daily realised and expected returns of cryptocurrencies, improving over both static latent factor models and pre-specified portfolios sorted on observable characteristics. Second, we show that expected returns are primarily driven by liquidity, volatility, and past performance. Third, our model provides evidence of a limited, although significant, spill-over of fundamental risk factors between equity and cryptocurrency markets.

Keywords: Instrumented PCA, Cryptocurrency markets, Asset pricing, Factor models, Risk premiums.

JEL Classification: G11, G12, G17, C23

Suggested Citation

Bianchi, Daniele and Babiak, Mykola, A risk-based explanation of cryptocurrency returns (October 10, 2021). Available at SSRN: https://ssrn.com/abstract=3935934 or http://dx.doi.org/10.2139/ssrn.3935934

Daniele Bianchi (Contact Author)

School of Economics and Finance, Queen Mary University of London ( email )

Mile End Road
London, London E1 4NS
United Kingdom

HOME PAGE: http://whitesphd.com

Mykola Babiak

Lancaster University Management School ( email )

Bailrigg
Lancaster, LA1 4YX
United Kingdom

HOME PAGE: http://https://sites.google.com/site/mykolababiak/home

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