Explaining cryptocurrency returns: A prospect theory perspective

Abstract

We investigate prospect theory’s ability to explain cryptocurrency returns using data concerning 1,573 cryptocurrencies over the period 2014–2020. In line with the theory’s predictions, we find that cryptocurrencies that are more (less) attractive from a prospect theory perspective earn lower (higher) future returns, suggesting that they tend to be overpriced (underpriced). On average, a one cross-sectional standard-deviation increase in the prospect theory value of a cryptocurrency reduces its next-week return by 0.71% relative to its peers. This effect is stronger among cryptocurrencies that are more difficult to arbitrage, but it is not confined to the micro-cap segment of the market.