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BITCOIN PRICE FORMATION: AN EMPIRICAL INVESTIGATION

BITCOIN PRICE FORMATION: AN EMPIRICAL INVESTIGATION

BITCOIN PRICE FORMATION: AN EMPIRICAL INVESTIGATION

Uploaded on: 2020-08-26

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Created in 2008 and rising to prominence in 2017, Bitcoin continues to generate controversy as to
whether it is a speculative asset or the harbinger of a future of global, decentralized commerce. The focus
of this paper is to investigate the properties of Bitcoin and its market by assessing asset specific factors
(users, hash rate, etc.) and traditional market factors (market risk, currency risk, etc.). The objective is to
quantify the impacts of these forces as drivers of Bitcoin returns and to develop a risk measurement
framework with the potential to inform future use cases.
The analysis is broken out into two parts. The first seeks to quantify the impact of asset specific
“supply and demand” factors with respect to Bitcoin’s daily price return and volatility and to determine
the relative efficiency of the nascent Bitcoin market. To do this a GARCH model is specified which
enables the measurement of return impacts and volatility within a single model. A back test and forecast
are then conducted to determine if the conditional value at risk and expected shortfall can be accurately
captured by the model. We determine the Bitcoin market is weakly efficient, returns are highly impacted
by supply and demand factors and that the specified value at risk model accurately describes the
exceptional volatility.
The second part incorporates a set of macro-financial variables into the model to determine
Bitcoin’s exposure to traditional sources of risk; such as stock and currency market returns. The results
show that Bitcoin is largely unimpacted by broad macro-financial variables once supply and demand
variables are properly accounted for. This suggests that although Bitcoin is a weakly efficient market it is
generally disconnected from worldwide capital and currencies market. This further suggests that Bitcoin
may have currently limited “real world” use cases which is an important consideration for investors
INTRODUCTION
Initially developed in 2008 by Satoshi Nakamoto and described in what has become his/her
seminal paper Bitcoin: A Peer-to-Peer Electronic Cash System1, Bitcoin has become both an object of
controversy and fascination in recent years and was the catalyst in what has become the burgeoning space
of cryptocurrency. Bitcoin is an unregulated, digital asset that is not issued as physical currency and,
unlike world currencies, is not associated with a government nor is it issued by a central monetary
authority. The system instead relies on what is dubbed a “decentralized distributed ledger” that is
maintained by blockchain technology. The blockchain is unique in that it is uses a cryptographic proof of
work algorithm to verify transactions on the Bitcoin network thus enabling users to send payments near
instantaneously while ensuring that payments are legitimate and subsequently preventing the possibility
of “double spending”.
Since its inception late in 2009, the USD exchange rate for Bitcoin (BTC) peaked on December
17th, 2017 at $19,982.60/BTC. As of this writing there are an estimated 1,658 registered cryptocurrencies
trading on 200 exchanges worldwide with a combined market cap of approximately $128B. Bitcoin
continues to dominate the space with a market cap of $68B; representing 53.1% of the total market
value2. The space has experienced a remarkable degree of maturation in a short period of time but is still
quite small in comparison to traditional equity and debt markets which, as of the end of 20l7, were
estimated to have global market capitalization rates of $70T and $92.2T, respectively.3
While cryptocurrency and Bitcoin have been the subject of substantial speculation, it has yet to
make any identifiable headway into the banking system or everyday commerce. It is estimated that in the
fourth quarter of 2017 only 11,291 businesses worldwide accepted Bitcoin as a valid form of payment;
the substantial underground Bitcoin economy notwithstanding.4 Additionally, banks have been reticent to
adopt the use of cryptocurrency primarily due to the ambiguous regulatory framework and lack of
traditional KYC (Know Your Client) guidelines. This is further complicated by confusion and speculation
as to the nature and use of Bitcoin. Given that so few businesses currently accept it as payment it can
2
hardly be said to be functioning as a currency in the traditional sense leading some to classify it simply as
a speculative or (at best) a hedging asset like gold or other precious Earth minerals.5
For these reasons there has been a lack of adoption within the sub-industry that might seem the
most natural fit for Bitcoin: financial services. The objective of this paper is to fill in those gaps and to
provide empirical insight into the nature of Bitcoin as a financial asset. Thus, the objectives of this paper
will be 2-fold: 1) to provide an assessment of the market efficiency and financial time series
characteristics of Bitcoin and accurately model the characteristic volatility using an ARCH/GARCH
model, 2) to assess Bitcoin’s exposure to traditional macro-financial and asset specific variables which
could plausibly be driving the return generating process. By accurately describing Bitcoin’s statistical
properties and characteristics it becomes possible for individuals and financial institutions to develop
appropriate use cases such as: allowing Bitcoin to serve as eligible collateral or issue Bitcoin denominated
debt.
The paper will be organized as follows: chapter 2 will discuss the relevant literature, most of
which is quite recent given Bitcoin’s relative novelty, chapter 3 presents an overview of how the
Bitcoin/blockchain technology works in order to provide readers with context for the analysis to follow,
chapter 4 reviews the data sources and software used, chapter 5 concerns the first objective of study and
evaluates Bitcoin’s daily price return and volatility series using variables unique to the network and
discusses the results in the context of efficient market theory, while chapter 6 analyzes the macrofinancial
exposure of Bitcoin using weekly time series data.

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ABSTRACT ................................................................................................................................................. ii
Chapter 1-Introduction ................................................................................................................................. 1
Chapter 2-Literature Review ......................................................................................................................... 3
Chapter 3-Stylized Facts about Bitcoin ...................................................................................................... 10
Chapter 4-Data and Software ...................................................................................................................... 12
Chapter 5- Objective 1-Analysis of Daily Bitcoin Returns and Volatility .................................................. 14
Section A: Econometric Approach ................................................................................................ 14
Section B: Empirical Results and Diagnostic Checks ................................................................... 20
Section C: Concluding Remarks on Objective 1 ........................................................................... 39
Chapter 6-Objective 2-Macro-Financial Analysis ...................................................................................... 40
Section A: Econometric Approach ................................................................................................ 40
Section B: Empirical Results and Diagnostic Checks ................................................................... 44
Section C: Concluding Remarks on Objective 2 ........................................................................... 48
Chapter 7: Conclusion ................................................................................................................................ 50
References .................................................................................................................................................. 51
Appendix .................................................................................................................................................... 54

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