Distant or close cousins: Connectedness between cryptocurrencies and traditional currencies volatilities

Abstract

This paper examines the volatility interconnection between the main cryptocurrencies and traditional currencies during the period of February 2014-September 2018 using both a framework proposed by Diebold and Yilmaz (2014) and the modified approach of Antonakakis and Gabauer (2020). Our results suggest that a 34.43%, of the forecast errors’ total variance is explained by shocks across the eight examined cryptocurrencies and traditional currencies, indicating that the remainder 65.57% of the variation is due to idiosyncratic shocks. Furthermore, we find that volatility connectedness varies over time, with a surge during periods of increasing economic and financial instability. When we aggregate both markets by blocks, we find that the block of traditional currencies and the block of cryptocurrencies are mostly disconnected with periods of mild net volatility spill over between both blocks. Finally, our findings suggest that financial market variables are the main drivers of total connectedness within the traditional currencies, while the cryptocurrency-specific variables are identified as the key determinant for the total connectedness within the traditional currencies, and a combination of both business cycles and cryptocurrency-specific variables explain the directional volatility connectedness between both blocks.