Abstract
This paper aims to select the best model or set of models for modelling volatility of the four most popular cryptocurrencies, i.e. Bitcoin, Ethereum, Ripple and Litecoin. More than 1000 GARCH models are fitted to the log returns of the exchange rates of each of these cryptocurrencies to estimate a one-step ahead prediction of Value-at-Risk (VaR) and Expected Shortfall (ES) on a rolling window basis. The best model or superior set of models is then chosen by backtesting VaR and ES as well as using a Model Confidence Set (MCS) procedure for their loss functions. The results imply that using standard GARCH models may yield incorrect VaR and ES predictions, and hence result in ineffective risk-management, portfolio optimisation, pricing of derivative securities etc. These could be improved by using instead the model specifications allowing for asymmetries and regime switching suggested by our analysis, from which both investors and regulators can benefit.
Highlights
Modelling volatility is crucial for risk management
1176 Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models were estimated for each cryptocurrency
Models that allow for asymmetry prevail in the superior set of models on the basis of both VaR and joint loss functions
Summary
Following the global financial crisis of 2008, the Basel III international regulatory framework for banks has imposed more stringent capital requirements, and enhanced risk management systems have been developed. Since the international financial system has had to face a new challenge, namely the introduction of decentralised cryptocurrencies, the first being Bitcoin, which was created in 2009 (Nakamoto, 2009). Interest in Bitcoin and other cryptocurrencies has risen considerably in recent years. Their market capitalisation increased from approximately 18 billion US dollars at the beginning of 2017 to nearly 600 billion at the end of that year, 1 and high returns have attracted new investors. Two big exchanges, i.e. the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE), started to trade futures on Bitcoin. As a result of these developments, central banks have been facing the question of whether or not cryptocurrencies should be regulated, given the numerous technical and legal issues involved
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