Is bitcoin the new digital gold? Ten years after the seminal work of Satoshi Nakamoto in 2008, at which time he introduced the bitcoin, a heated debate has started about this matter, and a wide audience has participated, including academics, practitioners (asset managers, financial advisors and investors) and journalists in the financial press. Although bitcoin and gold are two basically different assets in several respects (free of sovereign risk and independent from regulatory authorities), their statistical behavior leads us to consider if bitcoin – similarly to gold – could provide diversification benefits during downside market conditions. Such market conditions are a primary concern for investors.

To contribute to the current debate for the role of bitcoin as a new digital gold, we examine the potential benefits of bitcoin during extremely volatile periods in financial markets, using the multivariate extreme value theory. This statistical theory is the appropriate approach to model the tail dependence structure.

For our analysis, we focused on the correlation of extreme returns and we adopted a four-step research strategy.

Step 1. We considered a position in equity markets (Europe and the United States). We found that the extreme correlation increases during stock market crashes and decreases during stock market booms.

Step 2. We combined each equity market with bitcoin. We found that the correlation of extreme returns sharply decreases during both market booms and crashes. This means that bitcoin can play an important role in portfolio risk management during extreme market movements.

Step 3. We combined each equity market with gold. We found a similar result, confirming the well-recognized status of gold as a safe haven.

Step 4. We examined the joint behavior of bitcoin and gold. We found a low level of extreme correlation. This means that bitcoin and gold can be useful together in an equity portfolio in times of turbulence in financial markets.

Our findings showed that bitcoin can be considered as the new digital gold. However, gold is still important in an equity portfolio. To the question: “Is bitcoin the new digital gold?” we answer that both bitcoin and gold are the best choice.

Gkillas, K. and Longin, F. (2018). Is Bitcoin the New Digital Gold? Evidence from Extreme Price Movements in Financial Markets. http://dx.doi.org/10.2139/ssrn.3245571

This post presents a recent article by Gkillas and Longin published in Economics Letters (2018). In this article we investigate the relation between extreme return and transaction volume under the restrictions on transactions. We use bivariate extreme value theory to model the tail dependence structure. We show that restrictions on transactions have an impact on the activity of market participants.

The market activity and, therefore, the behavior of market participants is measured by the transaction volume. The stylized fact assumes a positive correlation between returns and volumes. However, contradictory results are obtained considering extremely volatile periods.

Such periods in combination with a financial crisis of a domestic origin, like the Greek crisis, can lead to strict intervention policies such as capital controls. The sovereign debt crisis in Greece led to the use of a financial support rescue mechanism by the European Monetary Union and the International Monetary Fund early in 2010. The domestic authorities imposed several restrictions on transactions. The Athens Stock Exchange stopped trading for more than two months and then opened to a dramatic decline. Greece became one of the few cases of a Eurozone country implementing such austerity policies.

In our work, we show that these long-term restrictions can be avoided. To this end, we apply bivariate extreme value theory. We show that capital controls have a significant negative impact on the activity of market participants. Therefore, we propose an automatic intra-day circuit-breaker mechanism when the market moves downwards and exceeds a specific threshold, in order to avoid not only the panic selling but long-term distortions for closing of the market.

Gkillas K. and F. Longin (2018) “Financial market activity under capital controls: lessons from extreme events” Economics Letters, 171C, 10-13.

You can download this paper via the following link: https://authors.elsevier.com/c/1XLFobZedijjr

This post presents a recent paper by Gkillas, Longin and Tsagkanos (2017). This paper introduces a new model with asymmetric time-exceedance of extreme shocks defined with optimal threshold derived from extreme value theory. It has implications in economics and finance.

Concept

We propose an innovative model, entitled asymmetric exceedance time model with optimal threshold, by combing the extreme value theory (distribution tails models) with regression techniques. Building on works related to the asymmetric phenomenon which has been widely documented in economic, finance and statistics, we examine the concept of asymmetry in extreme volatile periods. We use extreme value theory (peak-over-threshold method) to model extremes. We propose a procedure for the automatic computation of optimal thresholds, at the point where the fitting of the extreme value distribution is maximized. We define extreme shocks as exceedances over the optimal threshold and determine how the duration between past and present extreme shocks affects the dependent variable, introducing the temporal variability of extreme events.

Application

We present an empirical application to the exchange and equity markets. The mechanism of interactions between these markets is substantial for many outstanding issues in international economics and finance. Furthermore, both in theoretical and empirical literature, there is not consensus between the economic relation which connect these markets. We use daily data from S&P 500 and GBP/USD.

In this application we explore whether investors’ memory of past extreme events has a feedback effect at the time of an extreme shock. In other words, we separate the investors’ direct perceptions from the investors’ indirect expectations based on their memory. Our empirical findings suggest that the investors’ reaction at the time of an extreme shock is significantly affected by their memory and are consistent with the ‘portfolio balance’ models.

Usefulness

The understanding of interactions among financial variables in extreme volatile periods is crucial for several reasons. For example, theoretical economic models can be tested in extreme conditions or empirical findings can be useful in practice for asset managers (building portfolios based on diversification) and risk managers (defining hedging strategies against adverse events). However, the model is general and can be applied in any time series with heavy tails.

Reference: Gkillas K., F. Longin and A. Tsagkanos (2017) “Asymmetric Exceedance-Time Model: An Optimal Threshold Approach Based on Extreme Value Theory”. Available at SSRN: https://ssrn.com/abstract=3016145

Konstantinos Gkillas
University of Patras

New book on investing by Prof. Jean-Marie Choffray and Charles Pahud de Mortanges: “Ever invested. Ever Failed. No matter. Invest again. Invest better”

Ten thoughts, facts and rules :

• 1. Watch out! Events that did not happen in the past, and facts that did not materialize, are usually the best predictors of the future.
• 2. Most politicians are “naked” short-sellers. They sell what they don’t own and usually can’t provide.
• 3. Investment candidates (businesses) should ideally generate a recurrent level of return on equity (greater than the cost capital), as well as a high level of earnings per share growth (greater than operational growth and return on equity).
• 4. If you believe you understand financial statements, keep in mind that those who produce them usually don’t.
• 5. Sad Belgian joke. Banks whose assets were greater than GDP collapsed. Hundreds of years of growth in smoke. Nobody responsible!
• 6. Respect quarterly cycles. Invest on solid businesses (roe, Δeps, Δeps > roe, low peg, regular analysts estimates beats) at the end of their consolidation (bottoming) process. Avoid being invested when quarterly reports are released.
• 7. In today’s low growth environment, the most strategic “products” of any business might be its shares and its bonds.
• 8. As an investor, if you’re willing to pay managers/directors to do nothing, you will be amazed at how well they do it!
• 9. There are two opposing crowds on the market: those who sell what they don’t own (short-sellers), and those who buy what they can’t afford (margin-buyers). Good investors follow them. Great investors lead them.
• 10. Over time, financial markets don’t lie. Never. That’s why people – managers, directors, and leaders of all sorts – hate them!

Ever invested. Ever Failed. No matter. Invest again. Invest better

If you don’t see the link between these ten thoughts, facts and rules, you might consider having a look at Jean-Marie Choffray & Charles Pahud de Mortanges last book: Ever invested. Ever Failed. No matter. Invest again. Invest better. Their book provides a semi-ordered set of several hundred “experience-based” thoughts, facts and rules – allowing for some redundancy and randomness – whose any subset could provide a reasonable basis on which to build your own theory of investing. Painful and solitary work. But, your survival on the markets is at that price.

Protecting assets in non-parametric market conditions

In today’s chaotic economic and political environment, protecting assets, against all extreme – unpredictable, impossible, and even unthinkable – events, is the key to success. As we discussed in our contribution in the Wiley handbook Extreme Events in Finance edited by Prof. Longin, under such non-parametric market conditions, the analysis of the past is of limited help. As to the future, it might never exist! The present is all that matters, and that’s why investors usually become more concerned about the return of their money than about the return on their money. For a comprehensive discussion of this topic, refer to Extreme Events in Finance.

Prof. Jean-Marie Choffray
ESSEC Business School & University of Liège

Charles Pahud de Mortanges
University of Liège