Cryptocurrency Interlinkages and Portfolio Strategies During COVID-19

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Introduction

The cryptocurrency market has rapidly evolved into a significant asset class, attracting attention from investors, researchers, and policymakers worldwide. This growing interest stems from several factors, including declining public trust in traditional banking systems post-global financial crisis, the rise of smart technologies, and increasing acceptance by major corporations and even some governments. Understanding the dynamics within this market, especially the interconnections between major cryptocurrencies, is crucial for effective investment and risk management.

The COVID-19 pandemic created unprecedented volatility across global financial markets, including cryptocurrencies. Major digital assets experienced substantial price declines during the initial outbreak, with Bitcoin falling 19% from January to March 2020, including a single-day drop of 36% on March 13. This period of crisis provides a unique opportunity to examine how cryptocurrencies interact under extreme market conditions and how these relationships differ from normal market environments.

This analysis explores the return and volatility spillovers between three major cryptocurrencies—Bitcoin, Ethereum, and Litecoin—during both pre-COVID and COVID periods. Using high-frequency data and advanced modeling techniques, we provide insights into optimal portfolio construction, hedging strategies, and risk management approaches for cryptocurrency investors during both stable and crisis periods.

Understanding Cryptocurrency Market Connections

What Are Return and Volatility Spillovers?

Return spillovers occur when price movements in one cryptocurrency directly influence the price movements of another. For example, if Bitcoin's price increase tends to be followed by Ethereum's price increase, we observe a positive return spillover from Bitcoin to Ethereum.

Volatility spillovers happen when the degree of price fluctuation in one cryptocurrency affects the fluctuation levels in another. High volatility in Bitcoin might lead to increased volatility in other cryptocurrencies, indicating connected risk patterns across the market.

These spillover effects are crucial for investors to understand because they impact:

Previous Research on Cryptocurrency Connections

Multiple studies have examined relationships between cryptocurrencies before the COVID-19 pandemic. Research has shown that Bitcoin often serves as a primary transmitter of return and volatility effects to other cryptocurrencies, though it isn't always the dominant force. Other major cryptocurrencies like Ethereum and Litecoin also demonstrate significant influence on market dynamics.

Studies using daily data have revealed complex interconnection patterns, but until recently, few researchers had examined these relationships using high-frequency data or during major crisis periods. The COVID-19 pandemic provided a natural experiment to test how these relationships change under extreme market stress.

Research Methodology and Data Analysis

The VAR-AGARCH Model Approach

This analysis employs the Vector Autoregressive Asymmetric Generalized Autoregressive Conditional Heteroskedasticity (VAR-AGARCH) model, which offers several advantages for studying cryptocurrency relationships:

  1. Handles asymmetry: Recognizes that positive and negative shocks may have different impacts on volatility
  2. Avoids convergence problems: Overcomes technical issues that plague other multivariate models
  3. Comprehensive analysis: Allows simultaneous examination of return spillovers, volatility transmissions, and asymmetric effects
  4. Practical applications: Enables calculation of optimal portfolio weights and hedge ratios

The model analyzes hourly price data for Bitcoin, Ethereum, and Litecoin, representing approximately 76% of total cryptocurrency market capitalization as of April 2020.

Data Periods and Selection

The study examines two distinct periods:

This division allows for clear comparison between normal market conditions and the unprecedented volatility during the initial COVID-19 outbreak. The use of hourly data provides more granular insights than previous studies that relied primarily on daily data.

Key Findings on Return Spillovers

Bitcoin-Ethereum Relationship

The research reveals changing dynamics between Bitcoin and Ethereum across the two periods:

This shift suggests that during crisis periods, Bitcoin assumes a more dominant role in influencing Ethereum's price movements, possibly because investors view Bitcoin as a benchmark for the entire cryptocurrency market during times of uncertainty.

Bitcoin-Litecoin Dynamics

The relationship between Bitcoin and Litecoin shows even more dramatic changes:

This breakdown in relationship during the crisis period indicates that Litecoin may decouple from Bitcoin's influence during extreme market conditions, potentially offering diversification benefits when they're most needed.

Ethereum-Litecoin Connection

The interaction between Ethereum and Litecoin maintains some consistency:

The maintained influence of Ethereum on Litecoin during the crisis suggests a stable relationship that investors might leverage for forecasting purposes.

Volatility Transmission Patterns

Own-Market Effects

All three cryptocurrencies show significant own-shock and own-volatility spillovers during both periods, meaning their past volatility influences their current volatility. This pattern confirms the presence of volatility clustering—a phenomenon where periods of high volatility tend to be followed by more high volatility, and calm periods tend to persist.

The exception occurred in Bitcoin during COVID-19, where past shocks negatively affected current volatility, suggesting unusual market behavior during the crisis period.

Cross-Market Volatility Spillovers

The research reveals complex volatility transmission patterns:

Bitcoin-Ethereum:

Bitcoin-Litecoin:

Ethereum-Litecoin:

These complex patterns indicate that volatility transmission mechanisms change significantly during crisis periods, affecting diversification potential.

Asymmetric Effects

The research uncovered important asymmetry in how markets respond to positive versus negative news:

This reversal during the crisis period reflects increased investor sensitivity to bad news when markets are already stressed, potentially driven by herd behavior as investors simultaneously exit positions fearing further losses.

Correlation Patterns Through COVID-19

The study found that constant conditional correlations between all cryptocurrency pairs were significantly higher during the COVID-19 period compared to the pre-COVID period. Higher correlations reduce diversification benefits because assets move more in tandem, making it harder to reduce portfolio risk through combination.

This increased connectedness during crisis periods suggests that cryptocurrencies become more susceptible to common market factors when investors are panic-driven or when macroeconomic factors dominate asset-specific considerations.

Practical Applications for Investors

Optimal Portfolio Weights

Based on the research, investors should adjust their portfolio allocations during crisis periods:

BTC/ETH Portfolio:

BTC/LTC Portfolio:

ETH/LTC Portfolio:

These adjustments generally involve reducing exposure to the larger asset in each pair during crisis periods, reflecting changed risk relationships.

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Hedge Ratios and Hedging Costs

The research found that optimal hedge ratios increased for all cryptocurrency pairs during the COVID-19 period, indicating higher hedging costs. Specifically:

BTC/ETH Pair:

BTC/LTC Pair:

ETH/LTC Pair:

These increased ratios mean investors need to allocate more capital to hedging positions during crisis periods to achieve the same risk reduction.

Hedging Effectiveness

Despite higher costs, hedging effectiveness actually improved during the COVID-19 period for all cryptocurrency pairs. This counterintuitive finding suggests that while hedging becomes more expensive during crises, it also becomes more effective at reducing portfolio risk.

The improved effectiveness likely stems from more predictable relationship patterns during high-volatility periods, making statistical models more accurate.

Time-Varying Correlations and Robustness

Supplementary analysis using VAR-BEKK-AGARCH models confirmed that correlations between cryptocurrencies are indeed time-varying, supporting the use of dynamic hedging strategies rather than static approaches.

Time-varying hedge ratios generally showed similar patterns to the constant correlation models but with more responsiveness to changing market conditions. This supports the need for active management of cryptocurrency portfolios, especially during volatile periods.

Frequently Asked Questions

How did COVID-19 affect cryptocurrency relationships?

The pandemic significantly altered the relationships between major cryptocurrencies. Return spillovers changed directionality in some pairs, volatility transmissions intensified and became more complex, and correlations between assets increased substantially. These changes affected optimal portfolio weights, hedging ratios, and overall risk management approaches.

Why are hedging costs higher during crisis periods?

Hedging costs increase during crises because relationships between assets become more volatile and less predictable, requiring more capital to achieve the same level of protection. Additionally, increased market volatility generally raises the price of protection across all financial instruments.

Can cryptocurrencies still provide diversification during market crises?

While cryptocurrencies still offer some diversification benefits during crises, these benefits diminish due to increased correlations with each other and with traditional assets. However, careful pair selection and active weight adjustment can still provide meaningful risk reduction.

How often should investors rebalance their cryptocurrency portfolios?

During normal market conditions, quarterly rebalancing may suffice. During high-volatility periods or market crises, more frequent rebalancing (monthly or even weekly) may be necessary to maintain target risk levels and adapt to changing inter-asset relationships.

What is the most effective hedging strategy for cryptocurrency portfolios?

Dynamic hedging strategies that adjust to changing market conditions generally outperform static approaches. Combining positions across multiple cryptocurrency pairs with careful attention to changing correlation patterns tends to provide the most effective risk reduction.

How reliable are these findings for future crisis periods?

While specific numerical results might vary in future crises, the general patterns—increased correlations, changed spillover dynamics, and higher hedging costs—are likely to persist during future market stresses. The methodologies described can be adapted to new market conditions as they arise.

Conclusion and Implications

This research provides valuable insights for cryptocurrency investors, portfolio managers, and policymakers. The key takeaway is that cryptocurrency interrelationships change significantly during crisis periods, requiring adjusted investment and risk management strategies.

For investors, the findings emphasize the importance of:

For portfolio managers, the research offers concrete guidance on:

For policymakers, the findings highlight the need for:

The cryptocurrency market continues to evolve rapidly, and understanding the complex relationships between major digital assets is crucial for effective participation in this market. As the market matures and new crises emerge, the patterns observed during COVID-19 may provide valuable lessons for future risk management and investment strategy development.

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