The risks of trading on cryptocurrencies: A regime-switching approach based on volatility jumps and co-jumping behaviours

Leon Li

Applied Economics, 2024, vol. 56, issue 7, 779-795

Abstract: Previous research has shown volatility jumps and co-jumping behaviours in cryptocurrency markets. Motivated by these findings, we employ the herding effect and financial contagion channel to outline a theoretical framework of volatility-state-dependent correlations in cryptocurrency markets. We show that digital currency markets are more strongly correlated when experiencing an identical volatility regime, which echoes co-jumping behaviours addressed by the literature. Moreover, the strong correlation that occurs when the paired cryptocurrencies simultaneously experience a high volatility regime results in the least effectiveness of diversification in terms of a minimum portfolio risk reduction. Last but not least, the proposed state-dependent approach in this study proves effective at the task of risk forecasting and risk reduction for cryptocurrency portfolios, beyond the bivariate GARCH-based models, which are a pure and simple time-dependent approach.

Date: 2024
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DOI: 10.1080/00036846.2023.2170970

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