The Influence of Downside Market Risk on the Returns of Cryptocurrencies

The current study explores using 3-step regression analysis, how the downside market risk – completely new cryptocurrency risk factor in academic literature – influence the returns of this kind of instruments. Methodological foundation of the paper includes following elements: rolling window approach to estimate all individual parameters of the coins, portfolio analysis approach (6 models for 3 different formation types), and cross-sectional analysis approach (6 model specifications), based on Fama-Macbeth (1973) procedure. In this context, 5 risk factors are tested: regular market risk factor, downside and upside market risk factors, size factor, and momentum factor. The research sample contains almost 59,000 observations (weekly data) for the period between 2014 and 2018, comprising 916 the most liquid cryptocurrencies. As a result of analysis, it is illustrated that downside market risk is superior to regular market risk and upside market risk as explanatory variable for cryptocurrency returns. Instruments with the higher sensitivities to downside market risk tend to have the higher returns systematically. Moreover, great returns of cryptocurrencies are found to be a compensation for their exposures to the downside market risk. Premium for the mentioned risk factor is equal to 1.1-1.3% per week and significant for all reasonable levels. On the contrary, upside market component is completely irrelevant, causing the larger predictive power of downside market risk-based models. At the same time only downside market factor is not enough to explain the coin returns, however its combination with size and momentum factor shows excellent interpreting quality.