On a regime switching illiquid high volatile prediction model for cryptocurrencies

Abstract

PurposeThe current paper proposes a prediction model for a cryptocurrency that encompasses three properties observed in the markets for cryptocurrencies—namely high volatility, illiquidity, and regime shifts. As far as the authors’ knowledge extends, this paper is the first attempt to introduce a stochastic differential equation (SDE) for pricing cryptocurrencies while explicitly integrating the mentioned three significant stylized facts.Design/methodology/approachCryptocurrencies are increasingly utilized by investors and financial institutions worldwide as an alternative means of exchange. To the authors’ best knowledge, there is no SDE in the literature that can be used for representing and evaluating the data-generating process for the price of a cryptocurrency.FindingsBy using Ito calculus, the authors provide a solution for the suggested SDE along with mathematical proof. Numerical simulations are performed and compared to the real data, which seems to capture the dynamics of the price path of two main cryptocurrencies in the real markets.Originality/valueThe stochastic differential model that is introduced and solved in this article is expected to be useful for the pricing of cryptocurrencies in situations of high volatility combined with structural changes and illiquidity. These attributes are apparent in the real markets for cryptocurrencies; therefore, accounting explicitly for these underlying characteristics is a necessary condition for accurate evaluation of cryptocurrencies.

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“…Cryptocurrencies are modern decentralized digital currencies that rely on cryptography to safeguard and govern their transactions and the availability of these coins (Davidson and Naveed, 2013; Allison, 2015). Along with the advantages including less cost, portability, easy access and no third parties (Khan and Hakami, 2022), cryptocurrencies exhibit the traits of being very volatile and illiquid (Ciaian et al , 2018; Corbet et al , 2019; Gil-Alana et al , 2020; Fang et al , 2021; El-khatib and Hatemi-J, 2022; Irfan et al , 2023). Because of the cryptocurrency market’s extreme volatility, investors are exposed to substantial risks that might result in significant gains or losses.…”