Modeling Time-Varying Co-Movements Between Major Cryptocurrencies and Foreign Exchange Markets

Introduction

Just after the global financial crisis, the first decentralized cryptocurrency introduced in 2009 called Bitcoin, and since then, the literature has debated the notion of digital or virtual currency from various aspects. The success of Bitcoin has given rise to emerge many cryptocurrencies other than Bitcoin called altcoins. Cryptocurrencies are attractive for many users due to they provide pseudo-anonymity, low transaction costs, skyrocketing returns, and intraday hedging opportunities, and in addition, they are not required to be backed by any central authority for the legitimacy (Palazzi et al., 2021; Urquhart & Zhang, 2019; Yi et al., 2018). This attraction is not just related to the features of cryptos being monetary alternatives or investment opportunities but also the utilities of the Blockchain technology for the users (Chemkha et al., 2021). Thus, the literature focuses on the different aspects of cryptos (used interchangeably for cryptocurrencies throughout the chapter) to scrutinize their dynamics and characteristics (Elsayed et al., 2020).

The virtual currencies mainly aim to provide a new peer-to-peer payment system on the web without any necessity of a trusted financial institution (Chemkha et al., 2021). The literature defines a cryptocurrency as synthetic commodity money (Selgin, 2015) due to the crypto holds three functions of fiat money that are medium of exchange, store of value, and unit of account (Yermack, 2015), and its supply is scarce like commodity money despite no intrinsic value (Baur et al., 2018). The cryptos are also being considered a new investment opportunity for portfolio diversification because of their high returns, price volatilities, and low correlations between other financial assets (Yermak, 2015; Baur et al., 2018; Hsu et al., 2021); however, those have in-built economic risk during the bubble periods (Raza et al., 2022). Therefore, those currencies have been utilized for portfolio allocation besides fiat currencies or commodities for effective risk management and optimal hedging, especially during the turmoil periods (Hsu et al., 2021).

The markets for cryptos have continuously been encountering the boom and bust episodes somewhat similar to business cycles in macroeconomics. The cryptos have shown sharp fluctuations over time, especially in 2018, as risky assets due to those being a significant part of the investment market (Kostika & Laopodis, 2019). In this manner, Walther et al. (2019) put forward that the volatility of cryptocurrencies is mainly affected by global business cycles instead of country-specific dynamics. Moreover, foreign exchange markets are globally interconnected as cryptocurrency markets; thus, an impulse on the markets has the potential to create an immediate response on exchange rates.

The cryptos, particularly Bitcoin, have started to accept as the last resort against losing confidence in fiat currencies in economies like gold (Chemkha et al., 2021), furthermore Bitcoin is called as digital gold from time to time (Popper, 2016). Thus, Bitcoin has outstanding potential to threaten the supremacy of fiat currencies as an alternative money. Independently of the discussion on whether crypto is either a currency or an asset or both, is it possible to find dynamic relationships between the crypto- and fiat currencies via various structural links (Palazzi et al., 2021)? Most of the literature focused on the markets for cryptocurrencies themselves and the dynamic linkages among the cryptos; however, there is relatively less attention on the time-varying relationships between the crypto- and fiat currencies (Kostika & Laopodis, 2019). Several studies have examined the time-varying linkages between the crypto- and fiat currencies using different sets of currencies and modeling strategies (e.g., Baumöhl, 2019; Kostika & Laopodis, 2019; Kristjanpoller & Bouri, 2019; Liu & Tsyvinski, 2021; Raza et al., 2022; Umar & Guberava, 2020).