Volatility spillovers and interconnectedness between cryptocurrencies and traditional asset classes in emerging markets.

Abstract

Cryptocurrencies have emerged significantly in financial markets as a medium of exchange, seeking to disrupt traditional financial systems by allowing individuals to conduct peer-to-peer transactions without the interference of the third party. However, cryptocurrencies are marked by highly volatile prices due to their detachment from the traditional financial system. This volatility significantly spills over among cryptocurrencies and is suspected to extend to traditional asset classes, particularly in emerging markets. This is because emerging markets are often characterized by significant price fluctuations, driven by factors such as inflation rates, economic and political instability, and exchange rate volatility. As such, this study seeks to investigate volatility spillovers and interconnectedness between cryptocurrencies and traditional asset classes in emerging markets. To achieve the objective of this research, the study uses Bitcoin, Ethereum, Tether, Ripple, Litecoin, and Bloomberg Galaxy Cryptocurrency Index against the traditional asset indices of stocks, bonds, and commodities. The study incorporates daily closing prices from the 6th of October 2019 to the 31st of January 2024 and applies the Diebold and Yilmaz spillover approach to examine the nature of volatility spillovers between these cryptocurrencies and traditional assets. In order to capture the non-linear and time-varying nature of these volatility spillovers, the study employs the Time-Varying Parameter Vector Autoregressive (TVP-VAR) model which offers a more comprehensive analysis of the spillover effects over time. For the robustness of the results, the sample period was divided into two segments, (1) the whole sample period and (2) the period during the COVID-19 pandemic. The findings suggest time-varying volatility spillovers during both market crises and stable periods. However, cryptocurrencies exhibit greater internal influence than external influence, indicating that they operate within their own isolated market, with a weak connection to stocks, bonds, and commodities. These findings indicate that investors can view cryptocurrencies as a distinct asset, offering potential diversification benefits when combined with stocks, bonds and commodities in emerging markets. For policymakers, the weak connection between the two markets highlights the need to focus on internal market dynamics and regulations tailored to address risks within the cryptocurrency market without relying on traditional market mechanisms.