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Efficiency of cryptocurrency exchanges

Risk exposure analysis of identical assets

Written by O. Liljestrom

Paper category

Bachelor Thesis






Thesis: Efficientmarkets Fama (1965) believes that early chart theories do not produce valuable information about future price development, because these theories all assume that historical price information is important for paying attention to the "pattern" of future price behavior. Fama (1965) suggested that, compared with the buy and hold strategy, historical price data cannot be used to predict future trends or increase returns, and future price behavior follows the random walk theory. Random walk theory points out that historical price data does not reflect future price behavior, and price changes are independent and have no memory. Malkiel (1973) uses a coin toss to illustrate the random walk theory. The probability that the daily market closes higher or lower than the previous day is 50%. The simulation chart in the illustration forms different patterns and is often used for technical analysis. Malkiel (1973) concluded that the price pattern used to determine future price behavior is no more predictable than a series of coin flips. Fama (1965) distinguishes the intrinsic value and actual value of securities. Intrinsic value depends on the company's prospects, such as economics and politics. Intrinsic value can never be known accurately, so investors may diverge in price development. It is unreasonable to assume that price independence is perfect, and the random walk theory cannot fully conform to reality (Fama, 1965). Fama (1970) believes that the study of efficient markets can be divided into three types of testing: weak form testing, semi-strong form testing, and strong form testing. The weak form test mainly focuses on random walk theory and is interested in historical price data of assets. Semi-strong formal testing focuses on the correlation between public information and the speed of price adjustments. Strong formal testing explores whether certain individuals or groups can monopolize information that affects asset prices. Malkiel (1973) believes that with the technological advancement of society, every investor can immediately obtain all publicly and legally available information affecting prices, resulting in no investor being able to consistently "outperform the market." In fact, with all available information, the perfect reflection of the price of an asset is unrealistic. The meaning of transaction costs, available information, and price information are sufficient to improve market efficiency. However, these conditions may also become a potential source of market inefficiency (Fama, 1970). Empirical evidence shows that stock prices are too unpredictable in the short term, which proves the efficiency of the stock market and eliminates any arbitrage opportunities (Fama, 1970; Malkiel, 1973). Lo and MacKinlay (1988) presented evidence against the random walk theory and concluded that the random walk hypothesis cannot explain short-term stock market prices. The law of one price states that the same asset in a competitive market should have the same price no matter where it is located (Krugman et al., 2015). If there is a price difference, there will be an opportunity to take advantage of this and directly profit through trading without any risk or investment. Buying and selling the same assets at the same time to obtain potential profits is called arbitrage trading. However, since the exchange does not involve risk or investment, and the net present value is positive, investors take advantage of the trend to quickly parity, thereby eliminating arbitrage opportunities (Berk & DeMarzo, 2017). The two cornerstones of this research are the use of historical price data to explore potential market inefficiencies among cryptocurrency exchanges. The market inefficiency of cryptocurrencies has been well studied through the weak form test developed by Fama (1970) and several different statistical tests of long-term memory. The first hypothesis of this research focuses on the theory of market efficiency, and focuses on the efficiency of the cryptocurrency market. 3.2 Behavioral Finance Behavioral finance is a collaboration between finance and other social sciences, and it is a field that improves the knowledge of the financial sector (Shiller, 2003). Efficient market theory assumes that investors are always rational and try to maximize profits. According to Shiller (1981), new objective information cannot truly describe large price fluctuations, nor can it cause rational errors due to frequent repetitions. Shiller (1981) expressed concern about the efficient market model proposed by Fama (1970) because it did not describe the observed data movement. Shiller (1981) concluded that the market is inefficient for a long period of time, which may be caused by psychological variables, and therefore may “beat the market”. This is consistent with the early findings of Fama (1970) and Malkiel (1973). contradiction. Shiller (2015) believes that psychological decision-making can lead to abnormal events, such as the “Internet bubble”, similar to the recent cryptocurrency events that occurred during 2017-2019, accompanied by parabolic market trends (Blockchain, 2019b). Shiller defines this behavior as irrational exuberance (Shiller, 2015). The psychological aspect of market inefficiency is consistent with the prospect theory developed by Kahneman and Tversky (1979). They concluded that individuals overestimated their own risk management capabilities, leading to irrational economic decisions (Kahneman & Tversky, 1979). Psychology also shows that people overreact to unexpected and dramatic news events, leading to violations of Bayesian Rule 6 (Bondt & Thaler, 1985). Fama (1998) criticizes behavioral finance and believes that market efficiency should not be abandoned because of this. Read Less