Abstract
The author studies the explosive behaviors, causality relationships, and contagion effects between three financial markets using the daily closing prices of Bitcoin, gold, and West Texas Intermediate (WTI) oil prices for a sample period from July 19, 2010 to September 10, 2021. By employing the generalized supremum augmented Dickey-Fuller (GSADF) approach, the author finds significant evidence of bubble explosive behaviors in the Bitcoin and WTI prices—but not in the gold prices—and these periods mostly match with the periods of quantitative easing and financial stress. Besides, the test shows several short and long episodes of unilateral causal linkages from Bitcoin returns to oil price changes under homoscedasticity and heteroskedasticity assumptions. The results show no evidence for the contagion effect of bubbles between cryptocurrency and oil markets during the sample period.
TopIntroduction
Global markets and economies have experienced several economic and financial crises, triggered by political instability or conflicts, since early 2000. While the effects of some were limited to the country or region in which the crises took place, others caused global-scale destruction in both markets and economies due to the rapid development of economic globalization and financialization of commodities, such as oil. In early 2020, the world witnessed for the first time in a century a virus pandemic that spread rapidly around the globe. In the early stages of the COVID-19 pandemic, people continued their daily lives instead of acting cautiously, thinking that a cure would be found soon. However, the rapid increase in the death toll due to the pharmaceutical industry’s inability to produce an effective vaccine against the virus in a short time had a shock effect on the markets, causing unexpected levels of uncertainty and high volatility, and a sharp deterioration in investors’ risk appetite. Investors, who thought that this one was different from previous crises, tried to switch to cash instead of investing in safe-haven assets. Panic sales with the idea of “cash is king” caused asset prices to plunge rapidly. During the early period of uncertainty, the spot and futures prices of U.S. crude oil crashed into negative territory for the first time in history while Bitcoin and gold prices failed to act as a safe haven under extreme stock market conditions. In the following days, the markets calmed down as the uncertainty subsided, and investors searching for a safe haven caused prices to spike. The fact that individuals who were confined to their homes and who had no previous financial investment experience turned to the market to compensate for their income losses caused an excessive increase in asset prices. The question to be asked here is whether these behaviors created a positive or negative bubble in asset prices as in the past.
In the literature, a financial bubble has been defined as a rational or irrational deviation of the current price from its fundamental value. A rational asset bubble can be defined as a self-confirming divergence of asset prices from market fundamentals, which is equal to the expected present value of a stream of cash flows of dividend or coupon payments discounted with an appropriate rate, in response to extraneous variables (Diba & Grossman, 1988). On the one hand, a possible explanation for the formation of a rational bubble is that investors decide to hold or buy an overvalued asset with the expectation that they can sell it to someone else profitably. On the other hand, an irrational bubble emerges when investors are driven solely by psychological factors, such as sentiments, optimistic expectations, fashions, and fads, which are unrelated to the asset’s fundamental value and the relationship between its fundamental value and market price is disrupted (Dale et al., 2005). Accordingly, investors with self-fulfilling beliefs fail to correctly and in a timely fashion identify bubble formations and, therefore, indulge in herding (Tran, 2017).
Key Terms in this Chapter
WTI: It stands for West Texas Intermediate, and it is among the most heavily traded crude oil grades in the world (with Brent crude oil) and its price is tremendously sensitive to production and demand factors.
Gold: Gold is the most precious (a soft and yellow) metal that has been used as a common commercial medium of exchange, as a store of value, and as valuable jewelry. The price of gold can be affected by several factors including the production, demand, reserves, the value of the U.S. dollar, market volatility, inflation rates, geopolitical risks, financial/economic or pandemic crises, etc.
Financial Crisis: It is a situation when financial instruments and assets decrease suddenly and significantly in value. The 2007-2008 global financial crisis –originated in the US and spread out to other economies in a short time– is known as the worst economic disaster since the stock market crash of 1929
Bitcoin: It can be described as a decentralized digital or virtual currency, and it is the world's largest cryptocurrency in terms of market capitalization.
Contagion: It represents the transmission of negative shocks or crises from a particular market/economy or region to another.
Asset Bubble: It represents extreme (rational or speculative) price acceleration and deceleration, which cannot be explained by the market fundamentals.
Granger Causality: Briefly, it shows the relationship of cause and effect between underlying variables. Broadly speaking, however, it is a statistical hypothesis test for determining whether using one variable's current information increases the prediction probability of the future value of another variable.