THE NATURE OF THE BEAST (Part 1 of 3)
The Risk Protocol (TRP) is a pioneering DeFi primitive that tokenizes risk. Using a novel “splitting” mechanism, we create SMART tokens that are designed to harness crypto volatility. The following is an excerpt from a research study that we had published in 2023 titled “The Nature of the Beast”. The full report can be found here: https://www.riskprotocol.io/insights
In this paper, we examine several aspects of volatility for the 50 largest cryptocurrencies. For instance, we study the standard deviation and variance of returns, the autocorrelation of absolute and squared returns, the beta of returns vis-à-vis Bitcoin, the leverage effect of cryptocurrency returns versus the standard deviation of returns and how calendar effects impact the magnitude of cryptocurrency price returns. As far as we know, this is the most exhaustive study done to date on cryptocurrency returns and volatility.
Using data and insights gleaned from this exercise, we have developed highly sophisticated statistical volatility models that have been empirically proven to provide more accurate forecasts of crypto volatility than either implied or realized volatility. A primary motivation for undertaking this research is to be able to reliably forecast volatility. That is one of the critical inputs impacting pricing of certain very unique and sophisticated SMART Tokens created by The Risk Protocol. Before one can forecast, one must first understand the properties and the attributes of the underlying returns distribution. However, we were surprised at how little is understood of crypto volatility. Industry participants are blindly applying known properties of equity market volatility to crypto. Not only that, popular lore has ascribed specific properties to crypto but precious little research has been done to date to either prove or disprove them. It is our hope that this research serves to better inform investors and advisors about this nascent sector and provides a solid foundation for further research initiatives.
Our study shows that most stylized facts associated with other financial returns are also exhibited in cryptocurrency returns. However, crypto’s behavior is distinctly different in certain cases as illustrated in the summary findings below:
Inconsistent Leverage Effect: Equity markets exhibit a widely observed “leverage” effect, the phenomenon that an asset’s volatility is negatively correlated to its returns. Typically, rising asset prices are accompanied by declining volatility, and vice versa. We did not observe such a consistent effect in our analysis of cryptocurrencies. We generally found that 1/3rd of our universe exhibited a leverage effect, 1/3rd exhibited an “anti-leverage” effect and 1/3rd was inconclusive. This has potentially significant implications. It means that one can’t necessarily hedge long underlying crypto exposure by being long volatility. If the underlying crypto happens to be one that exhibits an anti-leverage effect, such a strategy would essentially double one’s downside exposure instead of hedging it.
Strong Persistent Calendar Effect: We also found that cryptocurrencies exhibit significant calendar effects. Specifically, there are distinct and persistent “hour of the day” and “day of the week” patterns in cryptocurrency volatility. We found that intraday volatility was persistently and significantly higher during hour 2 and hours 15–18 (UTC) each day. A similar analysis looking at daily returns across the week revealed that Saturdays and Sundays exhibited significantly lower volatility and volume relative to weekdays. The lower volumes on weekends makes intuitive sense. However, one would ordinarily expect the lower volumes on weekends to lead to higher volatility — our analysis indicates otherwise. We also found that US and Chinese holidays exhibited volatility patterns similar to weekends. These findings naturally have implications for crafting effective trading/investment strategies centered around optimal inter and intraday periods for buying/selling volatility and entering or exiting trading positions.
To be continued…
