University of Groningen

Bachelors thesis
A Quantitative Analysis of Bitcoins
Author:
T. van den Ende
Supervisor:
prof. dr. P.A. Bekker
June 24, 2013
Abstract
In this paper, the correlations between the returns of Bitcoins and returns of real nancial
assets is under consideration. To that end, 6-hourly data on the exchange rate of Bitcoins
in Euros and daily data on the closing yield of German & Spanish 10 year government
bonds were obtained. First, an overview of the asset under consideration, Bitcoins, and
the techniques used in this paper is given. These techniques comprise of the General Auto-
Regressive Conditional Heteroskedasticity method for modelling the time-varying volatility
of nancial time series and the Dynamic Conditional Correlation method for modelling the
time-varying correlation between various nancial assets. After practising these methods on
the Dow Jones, the government bonds and the DAX index, they are applied to construct dy-
namic conditional correlations between the daily returns of Bitcoins and German & Spanish
10 year government bonds.
Contents
1 Introduction 2
1.1 Problem Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2 Background 4
2.1 Bitcoins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 GARCH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.3 DCC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3 GARCH applied 8
3.1 Dow & Jones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3.2 Bitcoins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3.3 German & Spanish government bonds . . . . . . . . . . . . . . . . . . . . . . . . 9
4 DCC applied 12
4.1 German 10 year government bonds & the DAX index . . . . . . . . . . . . . . . 12
4.2 German & Spanish 10 year government bonds . . . . . . . . . . . . . . . . . . . . 13
5 Correlation between Bitcoins & government bonds 14
5.1 Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
5.2 DCC Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
5.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
6 Conclusion 17
7 gures 18
7.1 GARCH Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
7.2 DCC Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1
1 Introduction
In this report, Bitcoins are under consideration. Bitcoins are a relatively new, digital currency,
which is on the rise lately and is considered by many to be the next economic bubble. Nev-
ertheless, Bitcoins still are increasingly popular, with a current market capitalization of 913.5
million Euro[4], and their value, measured by the exchange rate in other currencies, increases as
well. Many consider its independence of the real nancial world and regulations, and the lack of
(possibly failing) intermediaries as its main advantage and as the foundation for its valuation.
These statements are, however, not based on any empirical, quantitative research. Therefore,
this report contains an elaborate quantitative research on this subject.
This issue raises many preliminary questions. First of all, what assets are a good representation
of the real nancial world? And how can the (in)dependence of nancial assets be measured?
Also, how can the reaction of the returns of Bitcoins on failing intermediaries be measured?
Furthermore, in order to be able to provide a meaningful comparative analysis, the return of
Bitcoins should be thoroughly investigated.
To be able to provide a sensible analysis on the relation of the return of Bitcoins with fail-
ing intermediaries, and as indicators of the real nancial world, distinctive European bonds will
be considered. Now that some preliminary questions have been posed, a more general problem
can be formulated.
1.1 Problem Formulation
The preceding introduction entails the following problem, which will be central in this report:
Are the returns of Bitcoins related to the returns of several European government bonds?
To be able to give a quantitative analysis of this problem, the preceding preliminary problems
should be tackled rst. First of all, for the Bitcoins, both the daily and 6-hourly returns of its
exchange rate in Euros will be considered, and as indicators of the real nancial world, daily
returns of German & Spanish 10 year government bonds will be considered. The former is
deemed as a relative safe investment, whereas the latter is, nowadays, regarded quite risky, due
to the ongoing nancial crisis in Europe, in which Spain was negatively involved. One would
expect that this negative involvement is reected in the evolution of the returns of the Spanish 10
year government bonds. Germany, on the contrary, was not a direct instigator of the crisis and
therefore, the returns of the German 10 year government bonds are expected to be imperturbable.
These expectations, as well as the underlying assumptions on the riskiness, will be investigated
by examining the evolution of the (volatility of the) returns of the individual assets. For the
latter, General Auto-Regressive Conditional Heteroskedasticity (GARCH) models will be devel-
oped. To fully understand the use of this type of models, the GARCH model will be applied to
the Dow Jones. After its use is demonstrated, GARCH models will be applied to the returns of
the exchange rate of Bitcoins in Euros.
2
Finally, after the individual examination of all these nancial assets and some preliminary com-
parisons, the cohesion of these assets will be investigated. To that end, Dynamic Conditional
Correlation (DCC) models will be constructed to estimate correlations. To get a grasp of the use
of DCC models, it will rst be applied to the DAX index and the German 10 year government
bonds, of which earlier similar research has been conducted[1], and on the Spanish & German
10 year government bonds. After its use is demonstrated, the DCC method can be applied to
the returns of Bitcoins and the returns of the Spanish & German 10 year government bonds,
hopefully yielding sensible results.
It is expected that this analysis will show that the returns of the exchange rate of Bitcoins
are uncorrelated with the returns of the German 10 year government bonds, since the returns of
this bond are likely to be imperturbable, whereas the returns of the exchange rate of Bitcoins
are likely to uctuate heavily. On the other hand, it is expected that returns of the exchange
rate of Bitcoins are correlated with the returns of the Spanish 10 year government bonds, since
the latter will probably be heavily inuenced by the Euro crisis, whereas Bitcoins are regarded
as a rewarding alternative to assets inuenced by the Euro crisis.
On a nal note, both the GARCH and DCC models will be estimated using Sheppards MFE
Toolbox[16].
3
2 Background
2.1 Bitcoins
In this section, a description of Bitcoins is given, and its advantages but also its risks are elab-
orated on. Bitcoins are a digital currency, similar to the Euro and Dollar. In essence, Bitcoins
are some sort of encrypted codes, which can be found online. Finding a new Bitcoin can be
compared to nding a new prime. It is not dicult to identify the rst primes (2,3,5 etc.), but
when arriving at higher orders, it becomes increasingly dicult to identify the next prime, in
fact, the computational time needed to nd a new prime goes to innity. Since nding a new
Bitcoin is that dicult, scarcity is involved, and scarcity is the foundation of the valuation of all
goods. To cope with the increasing computational time, many online so-called mining groups
have been created, in which the members computers are linked in a combined eort to nd
new Bitcoins, and since it is possible to split a Bitcoin in numerous parts, the resulting ndings
are equally divided amongst its members. Nowadays, new Bitcoins can still be found relatively
easy, which creates a modern-day gold-fever. But is this new nancial product an interesting
investment or not?
The exchange of Bitcoins is based on a p2p-system (peer to peer). This implies there is no
intermediary, such as a bank or a broker involved. Therefore, the safety of ones investments is
not inuenced by the malfunctioning and bankruptcy of banks, which, in the current nancial
situation, is considered as an huge advantage. This is the main foundation of the increase in the
popularity of this virtual currency in the past year. Nonetheless, Bitcoins bear some substantial
risks. First of all, Bitcoins are a globally accessible product, without boundaries and therefore
unrelated to governments, hence no regulations have been made yet, which implies no state will
provide in social security for this nancial product. In case of a full depreciation, this implies
all investments vanish. Furthermore, Bitcoins are stored in an online wallet, and there have
already been numerous cases in which these online wallets were hacked and emptied, which is
essentially pickpocketing. Another downside is the probability of the invention of new, safer,
digital currencies, which might lead to a full depreciation of Bitcoins[14].
Is this yet another nancial bubble, or is this a serious attempt to create a new, solid cur-
rency? Although some webshops and advocates already enabled paying with Bitcoins, the most
important distinction with other currencies, is linked to the origin of the need for a national
currency: tax payments. Unlike a government issued currency, Bitcoins cannot be used for this
purpose, and are therefore not fully acknowledged, which will eventually lead to its downfall.
The recent global awareness of Bitcoins led to a huge increase in its value, measured by its
exchange rate with other currencies, however, all negative news, mostly regarding some safety
breach, has quite an impact on Bitcoins as well, which suggests that Bitcoins are very volatile.[2]
Nevertheless, little quantitative research has been conducted so far, except for some analyses on
the dierent type of buyers of Bitcoins[7].
2.2 GARCH
The volatility of asset returns are mainly important to investors since it is a measure for the
stability of a nancial product. A high volatility implies a higher risk of depreciation, but it
might also lead to higher returns. Either way, the level of uncertainty increases with the volatility.
Furthermore, volatilities of dierent assets can be compared and correlations can be computed,
which creates the possibility of hedging a portfolio by selecting various assets which are not or
4
hardly correlated. Hence, asset return volatilities are central to nance, although they are not
directly observable. Nonetheless, it has been shown that volatilities behave in some characteristic
manner. They, for instance, are prone to clustering. Furthermore, volatilities evolve more or less
continuous, and they are subject to the leverage eect, which implies the eect of an increase
in returns on the volatility is dierent from the eect of a decrease in returns[17]. In this
report, volatilities of several time series will be considered. Financial asset return volatilities
are time varying. One way to model them, is to create a time series by computing, at time
t, the weighted standard deviation of the asset return of some preceding period. To that end,
both an exponentially and uniformly weighted framework are constructed, in which the prior 19
observations are included, by using the following formulas, where r
t
is the return of the asset at
time t:
(Uniform weight)
t
=

19
i=0
_
r
ti

1
20

19
i=0
r
ti
_
2
19
(Exponential weight)
t
=

_
19

i=0
e
i/20
_
r
ti

1
20

19
i=0
r
ti
_
2

19
i=0
e
i/20
These estimates do not account for the leptokurtosis of volatilities, hence they do not accu-
rately measure the protability in the tails. In 1982, Engle[8] proposed to model time-varying
conditional variance with Autoregressive Conditional Heteroskedasticity (ARCH), using lagged
disturbances. It appeared that the dynamic behaviour of conditional variance could only be
accounted for when using a high order of lagged variables, giving rise to the Generalized Autore-
gressive Conditional Heteroskedasticity (GARCH) model of Bollerslev[6], which is based on an
innite ARCH specication, reducing the number of estimated parameters to two. GARCH is
capable of registering the clustering (an autoregression eect), but still does not fully account for
the leptokurtosis. It, however, is the most commonly used method for computing the volatilities
of asset returns. In order to set up the GARCH model, rst, the return process r
t
needs to be
dened:
r
t
=
t
+
t
z
t
z
t
i.i.d.,
E[z
t
] = 0,
V ar(z
t
) = 1.
Then the GARCH(p,q) model is dened by:

2
t
= +
p

i=1

2
ti
+
q

j=1

2
tj
.
Here,

t
= r
t

t
=
t
z
t
.
From these estimated standard deviations of the returns, the annualized estimated volatility is
calculated, where T is the number of observations in one year in our dataset.:

t,ann
=
t

T.
5
The choice of parameters p and q for which the GARCH model has the best t is based on three
criteria, namely the Log-likelihood criterion, Akaike information criterion (AIC) and the Bayesian
information criterion (BIC). The Log-likelihood criterion amounts to choosing the model with
the highest Log-likelihood, whereas the AIC and BIC imply choosing the model with the lowest
value for the AIC and BIC. All three methods for the estimation of
t
will be applied to the
exchange rate of Bitcoins (in Euros) and the 10 year German and Spanish government bonds,
but rst it is applied on the Dow & Jones index.
2.3 DCC
The GARCH(p,q) model can be applied to a single nancial time series, but often a multivariate
time varying volatility model is of interest, since it includes the estimated standard deviations
of the returns of the individual time series as well as the estimated correlation between the re-
turns of the nancial time series under interest, which, as mentioned before, enables investors to
hedge their investments, a method to decrease the probability of default and the size of potential
losses. In this report, the main purpose for the construction of time varying correlations between
nancial assets is to verify whether or not the movements of the exchange rate of Bitcoins can be
related to the developments of other nancial product, which, in turn, reect the developments
in the entire nancial system.
A well-know multivariate model was proposed by Engle, the Dynamic Conditional Correlation
model[9][15]. The DCC model assumes that the zero-mean returns of n nancial time series are
conditionally multivariate normal, with expectation zero and a covariance matrix H
t
, that is:
r
t
N(0, H
t
),
H
t
= D
t
R
t
D
t
.
Here, D
t
is a n n diagonal matrix with entry (i, i) equal to
i,t
, the standard deviations of the
returns of asset i at time t, and R
t
is the time varying correlation matrix.
The estimation of a DCC model is two-fold: rst, a GARCH(p,q) model has to be tted to
each of the nancial time series individually, yielding an estimate of the standard deviations of
its returns. These estimated standard deviations serve to standardize the return process. That
is, for each of the n time series under consideration, the return process is transformed into a
white noise process:
r
t
N(0, H
t
) z
t
N(0, I),
z
i,t
=
r
i,t

i,t
i 1, .., n.
Then, the DCC(M,N) model is dened by:
Q
t
=
_
1
M

m=1

n=1

n
_

Q +
M

m=1

m
(z
tm
z

tm
) +
N

n=1

n
Q
tn
.
Here,

Q is the unconditional covariance of the standardized residuals resulting from the GARCH(p,q)
estimation. Furthermore, let Q

t
be a diagonal n n matrix with entry (i, i) equal to the square
root of q
i,i
, the (i, i)th element of Q
t
. Now, R
t
can be decomposed such that:
R
t
= Q
1
t
Q
t
Q
1
t
.
6
Element (i, j) of R
t
will be of the form:
q
i,j,t

q
i,i
q
j,j
=
i,j,t
.
Another way to model the time varying correlations, is to create a time series by computing, at
time t, the weighted correlation between two asset returns during some preceding period. To
that end, both an exponentially and uniformly weighted framework are constructed, in which
the current and prior 19 observations are included, by using the following formulas, where z
i,t
is
the standardized return of asset i at time t, calculated using the same method as for the DCC:
(Uniform weight)
i,j,t
=

19
k=0
z
i,tk
z
j,tk
19
(Exponential weight)
i,j,t
=
19

k=0
e
k/20
z
i,tk
z
j,tk

19
k=0
e
k/20
Throughout this report, a DCC(1,1) model will be applied to the standardized returns of the
nancial assets.
7
3 GARCH applied
3.1 Dow & Jones
For the Dow & Jones Industrial Average, daily closing prices were obtained, from March 1
1999, until February 28, 2013[12], to demonstrate how the GARCH model works and what its
characteristics are. A plot of these daily closing prices can be found in Figure 1. From 2002
until 2008, the prices of this asset rise steadily and in 2008, there is a considerable drop, which
is likely to be caused by the great nancial crisis, after which the Dow Jones Industrial Average
steadily recovered and currently is at its highest level again. From these prices, the zero-mean
daily returns are calculated by applying the following formulas, where T denotes the number of
observations in the dataset:
r
t
=
Price
t
Price
t1
1,
r =
T

t=1
r
t
T
,
r
t
= r
t
r.
First of all, the number of lags to include needs to be specied. The estimation of a GARCH(1,2)
and GARCH(2,2) model proved to be impossible, but the statistics the estimation of a GARCH(1,1)
and GARCH(2,1) model yielded, can be found in Table 1.
GARCH(1,1) GARCH(2,1)
Loglikelihood 11035.82 11050.88
AIC -3.1631 -3.1669
BIC -3.1578 -3.1598
Table 1: Log-likelihood criterion, AIC and BIC of a GARCH(1,1) and GARCH(2,1) model
estimation on the daily returns of the Dow Jones Industrial Average
The GARCH(2,1) model scores best on all three criteria, implying a GARCH(2,1) model ts best
to the data. In Figure 2, a plot of the annualized volatility of the returns of this asset, estimated
by the GARCH(2,1) method, the uniform weighted standard deviation and the exponential
weighted standard deviation can be found. Although the GARCH(2,1) estimate is slightly larger
in most cases, the estimates follow the same trends, which suggests the GARCH(2,1) is estimated
correctly, hence from here onwards, the GARCH estimates will no longer be compared to the
dierently weighted estimates of the standard deviation. Early 2008, there is a peak in the
annualized volatility of the returns, which can be related to the steep decline in the closing
price of the Dow Jones Industrial Average during that period. From here on, only annualized
volatilities will be considered in this report, unless stated otherwise.
3.2 Bitcoins
For the Bitcoins exchange rate in Euros, 6-hourly data was obtained, from July 17, 2010 until
April 4, 2013[3]. A plot of this exchange rate over time can be found in Figure 3. After January
2013, this exchange rate suddenly explodes, resulting in a 500% increase within 3 months. There
was a lot of media attention for Bitcoins around that period, and it became a worldwide hot
topic, which might explain this rigid increase in value. From the exchange rates, the zero-mean
6-hourly returns are calculated by applying the formulas stated in the previous section. The
8
estimation of a GARCH(2,2) model proved to be impossible, but the statistics the estimation of
a GARCH(1,1), GARCH(1,2) and GARCH(2,1) model yielded, can be found in Table 2.
GARCH(1,1) GARCH(1,2) GARCH(2,1)
Loglikelihood 8258.72 8275.04 8258.72
AIC -2.1380 -2.1417 -2.1375
BIC -2.1331 -2.1352 -2.1310
Table 2: Log-likelihood criterion, AIC and BIC of a GARCH(1,1), GARCH(1,2) and
GARCH(2,2) model estimation on the 6-hourly return of the exchange rate of Bitcoins
The Log-likelihood criterion, AIC and BIC indicate that the GARCH(1,2) model has the best
t. A plot of the volatility of the 6-hourly returns of this asset, estimated by the GARCH(1,2)
method, can be found in Figure 4. Between 2011 and 2012, the exchange rate is rather unstable
and in August 2012, there is a temporarily steep rise and decline in the exchange rate, which is
reected well in the estimation of the volatility of the returns by means of quickly alternating
peaks and drops.
To compare the eect of the number of observations included in the analysis, also daily data for
the same period were obtained. The statistics the estimation of a GARCH(1,1), GARCH(1,2),
GARCH(2,1) and GARCH(2,2) model yielded, can be found in Table 3.
GARCH(1,1) GARCH(1,2) GARCH(2,1) GARCH(2,2)
Loglikelihood 1314.97 1333.64 1326.21 1333.64
AIC -1.3579 -1.3751 -1.3674 -1.3731
BIC -1.3427 -1.3549 -1.3472 -1.3478
Table 3: Log-likelihood criterion, AIC and BIC of a GARCH(1,1), GARCH(1,2), GARCH(2,1)
and GARCH(2,2) model estimation on the daily return of the exchange rate of Bitcoins
The Log-likelihood criterion, AIC and BIC indicate that the GARCH(1,2) model has the best
t. In Figure 5, a plot of the estimated volatility of the returns of this asset, based on 6-
hourly and daily data, is given for the period from February 22, 2012 until February 21, 2013,
to zoom in on the dierences. The 6-hourly estimates uctuate more than the daily estimates,
moreover, the daily estimates resemble a moving average of the 6-hourly estimates. This implies
the 6-hourly estimates contain more information, which is rather intuitive, since the Bitcoins are
prone to substantial uctuations within a 24 hour time period, which the daily estimates neglect.
Therefore, the 6-hourly estimates form a better basis, in terms of information, for the following
discussion.
3.3 German & Spanish government bonds
For the German 10 year (N) government bond yields with face value(FV) 100 and for the Spanish
10 year government bond yields with face value 100, daily closing data were obtained, from Febru-
ary 27, 2008, until June 6, 2013 and from February 2, 2006 until June 6, 2013, respectively[11].
From these yields (y), the daily return can be computed by applying the following formulas,
where T denotes the number of observations in the dataset:
9
Price(t) = FV e
yN
,
r
t
=
Price
t
Price
t1
1,
r =
T

t=1
r
t
T
,
r
t
= r
t
r.
In Figure 6, a plot of the prices over time are given. The German 10 year government bond
(from here onwards abbreviated to Ger10yr) prices show an upward trend. One explanation
could be that investors tend to resort to government bonds during nancial crises, but the Span-
ish 10 year government bond (from here onwards abbreviated to Sp10yr) prices do not show
that trend. This might well be caused by the Euro-crisis. Spain faced a large decit, a growing
debt and a high unemployment rate, which resulted in the severe downgrading of the rating of
Spain by credit-rating agencies from late 2011 until June 2012, leading to the various price drops
and peaks[10]. The Spanish economy has undergone some transformations and some positive
numbers have been published lately[5], leading to a decrease in the yields and an increase in the
prices, which is reected in Figure 6 as well.
For the daily returns of the Ger10yr, the estimation of a GARCH(2,2) model proved to be
impossible, but the statistics the estimation of a GARCH(1,1), GARCH(1,2) and GARCH(2,1)
model yielded, can be found in Table 4.
GARCH(1,1) GARCH(1,2) GARCH(2,1)
Loglikelihood 5164.69 5165.37 5164.69
AIC -3.8383 -3.8373 -3.8368
BIC -3.8267 -3.8218 -3.8213
Table 4: Log-likelihood criterion, AIC and BIC of a GARCH(1,1), GARCH(1,2) and
GARCH(2,1) model estimation on the daily return of the Ger10yr
The AIC and BIC indicate that the GARCH(1,1) model results in the best t, whereas the Log
likelihood criterion suggests that the GARCH(1,2) model has the best t. For the daily returns
of the Sp10yr, the estimation of a GARCH(2,2) model proved to be impossible, but the statistics
the estimation of a GARCH(1,1), GARCH(1,2) and GARCH(2,1) model yielded, can be found
in Table 5.
GARCH(1,1) GARCH(1,2) GARCH(2,1)
Loglikelihood 6856.47 6858.24 6856.47
AIC -3.6439 -3.6437 -3.6428
BIC -3.6350 -3.6320 -3.6310
Table 5: Log-likelihood criterion, AIC and BIC of a GARCH(1,1), GARCH(1,2) and
GARCH(2,1) model estimation on the daily return of the Sp10yr
The Log likelihood criterion suggest that the GARCH(1,2) model is the best t, whereas the
AIC and the BIC indicate that the GARCH(1,1) model results in the best t. Therefore, the
GARCH(1,1) is taken to be the best t for both the assets.
10
For the Sp10yr & Ger10yr, a plot of the volatility of the daily returns, estimated by the
GARCH(1,1) method, can be found in Figure 7. The uctuations in the yield and prices for
the Sp10yr, caused by the impact of the Euro crisis and the lately improving economic situation,
are reected by a substantial increase in the volatility of the returns, and the major deprecia-
tions occur simultaneously with the announcements of the downgrading of the Spanish rating
by credit-rating agencies[13]. The volatility of the return of the Ger10yr uctuates around a
constant rate, with an occasional peak in late 2011, in the midst of the Euro crisis. In compari-
son, the volatilities start harmoniously, but, from late 2009 onwards, suddenly move in opposed
directions. In the next section, these underlying relations are thoroughly investigated, as well as
the relation of the return of Bitcoins with the return on the prices of the Ger10yr and Sp10yr,
by means of a Dynamic Conditional Correlation (DCC) model.
11
4 DCC applied
4.1 German 10 year government bonds & the DAX index
First, the DCC model is applied to the returns of the Ger10yr and the DAX, the main stock index
of Germany, of which daily closing prices are obtained from January 02, 2001 until June 12, 2013,
which are transformed into daily zero-mean returns using the formulas developed in Section 3.1.
The rst step of the estimation of the DCC model is standardizing the zero-mean returns, using
standard deviations estimated by a GARCH(p,q) model. A GARCH(1,1) model has already
been estimated for the Ger10yr returns, resulting in estimates of the standard deviation which
can be used to standardize the zero-mean returns, as discussed in Section 2.3. For the returns
of the DAX index, the estimation of a GARCH(1,2) & GARCH(2,2) proved to be impossible,
but the estimation of a GARCH(1,1) & GARCH(2,1) model yielded the statistics mentioned in
Table 6.
GARCH(1,1) GARCH(2,1)
Loglikelihood 9219.48 9227.75
AIC -2.9083 -2.9103
BIC -2.9026 -2.9026
Table 6: Log-likelihood criterion, AIC and BIC of a GARCH(1,1) and GARCH(2,1) model
estimation on the daily return of the DAX index
The criteria indicate that the GARCH(2,1) model is the best t, and the resulting estimated
standard deviations of the returns were used to standardize the zero-mean returns. Now that
the standardized zero-mean returns are established, a DCC(1,1) model can be estimated. As
stated before, the daily closing prices of the DAX index are obtained from January 02, 2001
until June 12, 2013. Nonetheless, a DCC model can only be constructed for time series with an
equal number of observations, hence only the intersection of time-instances is considered, which
comprises the daily closing prices of both assets from February 27, 2008, until June 6, 2013.
The estimated time varying correlation between the returns of the DAX index and the Ger10yr
is plotted in Figure 8. Throughout the whole period, this correlation is negative, starting with a
value of -0.8, after which the correlation revolves around approximately -0.53, with some outliers
near -0.8 and -0.22. One explanation of the negative correlation in this period could be that in-
vestors tend to resort to the safer regarded government bonds during nancial crises. Therefore,
the Ger10yr thrives well during the credit & Euro crisis, whereas the DAX index suers from it.
Nonetheless, in their report, Wong & Vlaar[1] found a positive dynamic correlation from 1988
until 1999, indicating that in that period, the explanation mentioned did not have a (decisive)
inuence.
In Figure 9, the estimated dynamic conditional correlation is plotted against the manually created
conditional correlation, using both an uniform and an exponential framework. These crudely es-
timated conditional correlations exceed -1 every now and then. Since a correlation lower than -1
is theoretically impossible, these values are not depicted. The estimates move harmoniously, but
the weighted conditional correlations have a higher dispersion and therefore, their outliers are
extremer. This is an indication that the DCC estimates are constructed in a proper way, hence
from here onwards, the DCC estimates will no longer be compared to the dierently weighted
estimates of the correlation.
12
4.2 German & Spanish 10 year government bonds
In Section 3.3, a GARCH(1,1) model has already been estimated for both the Ger10yr and Sp10yr
returns, resulting in estimates of the standard deviations which can be used to standardize the
zero-mean returns, as discussed in Section 2.3. With these standardized returns, a DCC(1,1)
model can be estimated. The assets have dierent datasets, consisting of a dierent amount
of observations, whereas a DCC model can only be constructed for time series with an equal
number of observations. To cope with these dierences, the whole dataset of the Ger10yr and
only those observations of the Sp10yr that occur at the same time as the observations of the
Ger10yr are included, which comprises the daily standardized zero-mean returns from February
27, 2008, until June 6, 2013. The prices of the bonds, depicted in Figure 6, and the volatilities
of the returns of the bonds, depicted in Figure 7, suggest that until March 2010, the returns of
the bonds have a positive correlation, and from March 2010 until March 2013, the bonds have a
negative correlation, with its most negative value around the July, 2011.
In Figure 10, the estimated time varying conditional correlation between the daily returns of
the Ger10yr and Sp10yr is plotted. This estimated conditional correlation exceeds 1 occasion-
ally, which is theoretically impossible, hence these values are omitted. The correlation reects the
assumptions based on Figure 7 quite well, that is, rst there is a positive correlation, and indeed
from March 2010 onwards, the correlation attains negative values, for which a possible cause
was already given, namely the Euro crisis, since in the mid-2010, the Bank of Spain announced
an estimate of the amount of potential troubled loan exposure, which considerably exceeded the
loss the Spanish banking system was able to cope with[10]. Slow recovery periods, in which the
correlation between the returns approaches and passes zero, are followed by steep drawbacks,
which is reected by the movements of the prices.
In this section two DCC models have been established and analysed to demonstrate its use,
and in the following section the DCC method is applied to the return of the exchange rate of
Bitcoins and the return of the Spanish & German 10 year government bond.
13
5 Correlation between Bitcoins & government bonds
Prior to this section, applications of the GARCH and DCC model have been demonstrated. In
this section, the gained experience with these models is used to return to the core of this research.
In Sections 3.2 and 3.3, a preliminary research on the 6-hourly returns of the exchange rate of
Bitcoins and the daily returns of the Sp10yr & Ger10yr has already been conducted, a rst
observation on the dierences in the individual volatility of the returns of the bonds has already
been made and a dynamic conditional correlation between the return of the bonds has been
estimated. Here, the DCC method will be applied to obtain dynamic conditional correlations of
the daily returns of the exchange rate of Bitcoins and of the returns of the Sp10yr & Ger10yr,
but rst a more elaborate hypothesis on these correlations is formulated.
5.1 Hypothesis
In the problem formulation, a supercial hypothesis regarding the potential correlation between
the daily returns of the exchange rate of Bitcoins and the daily returns of the Sp10yr & the
Ger10yr has already been posed. In the previous sections, these assets were investigated, which
enables a more thorough, adequate hypothesis regarding the potential correlation.
The initial assumption of a correlation between the daily returns of Bitcoins and Sp10yr was
based on the following reasoning. A property of Bitcoins is that it is not linked to any regula-
tion, and no intermediary is needed. Therefore, Bitcoins are not prone to bad performances
of the banking system or the European system as a whole, which is considered an advantage.
This is also the foundation for its increased popularity, since Bitcoins are an alternative for the
failing (government) bonds. This suggests that a decrease in the returns of Sp10yr, which are
considered sensitive to the performances of the European (banking) system, will lead to an in-
crease in the returns of Bitcoins, which implies there is a negative correlation between the daily
returns of the exchange rate of Bitcoins in Euros and the daily returns of the price of the Sp10yr.
Figure 3 indicates that the price of Bitcoins increases up until the rst half of 2011, decreases
the second half of 2011 and slowly increases from 2012 onwards, every now and then disrupted
by temporarily drawbacks. Figure 6 indicates that the price of the Sp10yr decreases until the
end of 2010, alternates between peaks and drawback from there until 2012, decreases the rst
half of 2012 and increases thereafter. These opposite movements suggest a negative correlation
as well. Therefore, a negative correlation is expected.
In the problem formulation, it was stated that the correlation between the daily returns of the
Ger10yr and the Bitcoins are expected to be zero. This was based on the presumed imperturba-
bility of the returns of the Ger10yr on the one hand, despite the credit & Euro crises, and the
presumed periodically alternating positive and negative returns of the Bitcoins on the other hand.
The observed non-diminishing upward trend of the price of the Ger10yr in the time period
under investigation strengthens the assumption that, contrary to the Sp10yr, the returns of the
Ger10yr are not negatively inuenced by the Euro crisis, but it rescinds the original assumption
of imperturbability. The returns of the Ger10yr appear to thrive on the crisis instead, which,
based on the preceding reasoning, also holds for the returns of Bitcoins. That, combined with
the observation that the exchange rate of the Bitcoins in Euros shows an every now and then
disrupted upward trend from 2012 onwards, leads to an adapted hypothesis, namely a positive
correlation.
14
5.2 DCC Analysis
In the previous section, the daily standardized zero-mean returns of the Ger10yr and Sp10yr
have already been constructed. In Section 3.2, a GARCH(1,2) model has been estimated for the
6-hourly return of the exchange rate of Bitcoins, resulting in estimates of the standard deviations.
In order to construct the daily standardized zero-mean returns of the exchange rate of Bitcoins,
the 6-hourly returns and the estimated standard deviations of the 6-hourly zero-mean returns
of the exchange rate of Bitcoins need to be transformed into daily estimates. Therefore, the
(estimated standard deviations of the) observed returns within a day are accumulated for every
day, using the following formulas:
r
t,daily
=
_
T
t

i=1
(r
t,i
+ 1)
_
1,

t,daily
=

_
T
t

i=1

2
t,i
.
Here, T
t
denotes the number of 6-hourly observations during day t, which is 4 most of the time,
but occasionally an observation is missing. From these transformed data, the daily zero-mean
returns can be computed, using the formulas developed in Section 3.1. It appears that this
transformation has little impact on the estimates, and therefore a full analysis of this impact is
omitted. From these daily zero-mean returns and estimated daily standard deviations of the re-
turn, the daily standardized zero-mean returns of the exchange rate of Bitcoins are constructed,
using the formulas developed in Section 2.3.
As stated before, the number of observations of the time series under considerations should be
aligned to enable the estimation of a DCC model, hence only the intersection of time-instances
is considered, which comprises the daily standardized zero-mean returns of the three assets from
July 17, 2010 until April 4, 2013. The dynamic conditional correlations between the daily re-
turns of the assets under investigation, estimated by a DCC(1,1) model, are depicted in Figure 11.
5.3 Results
Nearly all estimated conditional correlations between the daily return of the exchange rates of
Bitcoins and the daily return of the Ger10yr attain negative values, with a mean value of -.0257
and nearly all estimated conditional correlations between the daily return of the exchange rates
of Bitcoins and the daily return of the Sp10yr attain positive values, with a mean value of 0.0368.
This observation indicates that the daily return of the exchange rate of Bitcoins does not stand
alone, that is, there is some cohesion, although little, between the evolution of this return and
the real nancial world, which is a remarkable result.
Nonetheless, this cohesion with the nancial assets chosen in this report deviates from the stated
expectations. Where a negative correlation with the daily return of the Sp10yr and a positive
correlation with the daily return of the Ger10yr was presumed, the opposite proves to be true.
Several explanations for this observation can be given. One might argue that both Bitcoins
and the Sp10yr are regarded as risky assets, whereas the German government bonds are deemed
more safely. In nancial crises, this would imply that investors resort to the Ger10yr instead of
15
the Sp10yr and Bitcoins, leading to the observed correlations. There are plenty other, equally
sound possible causes for the observed correlations. However, these results refute the most cited
explanation for the popularity of Bitcoins, its independence of the European banking system
and its current bad performances, since, apparently, a decrease in the return of the Sp10yr, an
indication of the aggravation of the Euro crisis, does not result in an increase in the return of
the exchange rate of Bitcoins.
The correlation between the daily return of the exchange rate of Bitcoins and the daily return
of the Ger10yr starts around -0.1 but has an upward trend, whereas the correlation between the
daily return of the exchange rate of Bitcoins and the daily return of the Sp10yr starts around 0.1,
then uctuates between 0 and 0.05 for a while, after which it has a diminishing trend. Moreover,
both conditional correlations seem to converge to zero in the time period under investigation.
It might well be that, in the near future, the correlations switch sign, or that the return of the
exchange rate of Bitcoins becomes independent of the nancial assets under consideration, which
would imply that the correlations will continue to converge to zero. A future research similar to
this one might be able to expose the true development of the correlations.
16
6 Conclusion
In this report, the main focus was on nding potential correlations between the returns of Bit-
coins and returns of real nancial assets. To that end, 6-hourly data on the exchange rate of
Bitcoins in Euros and daily data on the closing yield of German & Spanish 10 year government
bonds were obtained and the GARCH & DCC methods were applied.
First of all, non zero correlations were found, and the observation that almost all of them attain
negative/positive values throughout the time period under investigation, respectively, indicates
that there actually is a negative/positive eect between the nancial assets under consideration,
although little. Nevertheless, both correlations tend to zero over time, hence, a future research
might elaborate on the signicance of the observed correlations.
Although the recent popularity of Bitcoins is often attributed to its independence of the Eu-
ropean/international banking system, this research has shown that the daily return of Bitcoins
is positively correlated with the daily return of Spanish 10 year government bonds, and nega-
tively correlated with the daily return of German 10 year government bonds, which contradicts
the assumptions that Bitcoins are bought more often as a reaction to the Euro crisis.
Moreover, the observations indicate that Bitcoins do not behave independent from the real
nancial world at all, in fact, there is a clear distinction between the relation of Bitcoins with
presumed volatile assets, and the relation of Bitcoins with assets that are deemed trustworthy,
that is, the returns of the exchange rate of Bitcoins are positively connected to the returns of
the volatile asset under consideration, the Spanish 10 year government bonds, and negatively
connected to the returns of the safe asset under consideration, the German 10 year government
bonds.
Finally, a future research might investigate the relation of these correlations over time and might
clarify whether the correlations converge to zero, switch sign, or develop another trend.
17
7 gures
7.1 GARCH Analysis
Dow Jones
01Jan1999 01Jan2002 01Jan2005 01Jan2008 01Jan2011 01Jan2014
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
x 10
4
Time
P
r
i
c
e
Figure 1: Daily closing prices of the Dow Jones Industrial Average, from March 1 1999, until
February 28, 2013
18
01Jan1999 01Jan2002 01Jan2005 01Jan2008 01Jan2011 01Jan2014
0
0.2
0.4
0.6
0.8
1
1.2
1.4
Time
E
s
t
i
m
a
t
e
d
v
o
l
a
t
i
l
i
t
y


GARCH
UNI
EXP
Figure 2: Annualized volatility of the daily return of the Dow Jones Industrial Average, estimated
by a GARCH(1,1) model and both a uniform & exponential framework, from March 2 1999, until
February 28, 2013
19
Bitcoins
01Jul2010 01Jan2011 01Jul2011 01Jan2012 01Jul2012 01Jan2013 01Jul2013
0
50
100
150
Time
E
x
c
h
a
n
g
e

r
a
t
e
Figure 3: 6-hourly exchange rate of Bitcoins in Euros, from July 17, 2010 until April 4, 2013
20
01Jul2010 01Jan2011 01Jul2011 01Jan2012 01Jul2012 01Jan2013 01Jul2013
0
2
4
6
8
10
12
14
Time
E
s
t
i
m
a
t
e
d

v
o
l
a
t
i
l
i
t
y
Figure 4: Annualized volatility of the 6-hourly return of the exchange rate of Bitcoins, estimated
by a GARCH(1,2) model, from July 17, 2010 until April 4, 2013
21
Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
Time
E
S
t
i
m
a
t
e
d
v
o
l
a
t
i
l
i
t
y



daily

6hourly
Figure 5: Annualized volatilities of the 6-hourly and daily returns of the exchange rate of Bitcoins,
estimated by GARCH(1,2) models, from 22 February, 2012 until 21 February, 2013
22
German & Spanish 10 year government bonds
01Jan2008 01Jan2009 01Jan2010 01Jan2011 01Jan2012 01Jan2013 01Jan2014
45
50
55
60
65
70
75
80
85
90
Time
P
r
i
c
e


Spain 10 yr
German 10 yr
Figure 6: Daily closing prices of German & Spanish 10 year government bonds from January 1,
2008 until June 6, 2013
23
01Jan2008 01Jan2009 01Jan2010 01Jan2011 01Jan2012 01Jan2013 01Jan2014
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Time
E
s
t
i
m
a
t
e
d
v
o
l
a
t
i
l
i
t
y



Spain10yr

German10yr
Figure 7: Annualized volatilities of the daily returns of the German & Spanish 10 year government
bonds, estimated by GARCH(1,1) models, from January 1, 2008 until June 6, 2013
24
7.2 DCC Analysis
01Jan2008 01Jan2009 01Jan2010 01Jan2011 01Jan2012 01Jan2013
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
E
s
t
i
m
a
t
e
d
c
o
r
r
e
l
a
t
i
o
n
Time
Figure 8: Correlation between the daily returns of the DAX index & German 10 year government
bonds, estimated by a DCC(1,1) model, from February 27, 2008, until June 6, 2013
25
01Jan2008 01Jan2009 01Jan2010 01Jan2011 01Jan2012 01Jan2013
1
0.5
0
0.5
E
s
t
i
m
a
t
e
d
C
o
r
r
e
l
a
t
i
o
n
Time



uniform

exponential

dcc
Figure 9: Correlation between the daily returns of the DAX index & German 10 year government
bonds, estimated by an uniform/exponential framework & a DCC(1,1) model, from February 27,
2008, until June 6, 2013
26
01Jan2008 01Jan2009 01Jan2010 01Jan2011 01Jan2012 01Jan2013
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8
1
E
s
t
i
m
a
t
e
d
c
o
r
r
e
l
a
t
i
o
n
Time
Figure 10: Correlation between the daily returns of the Spanish & German 10 year government
bonds, estimated by a DCC(1,1) model, from February 27, 2008, until June 6, 2013
27
01Jul2010 01Jan2011 01Jul2011 01Jan2012 01Jul2012 01Jan2013
0.1
0.05
0
0.05
0.1
0.15
E
s
t
i
m
a
t
e
d
c
o
r
r
e
l
a
t
i
o
n
Time



Sp,BTC

Ger,BTC
Figure 11: Correlation between the daily returns of the exchange rate of Bitcoins and the daily
returns of the Spanish & German 10 year government bonds, estimated by a DCC(1,1) model,
from July 17, 2010 until April 4, 2013
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