Investor Sentiment, Unexpected Inflation, and Bitcoin Basis Risk

• Published date: 01 November 2024
• Author: Thomas Conlon,Shaen Corbet,Les Oxley
• Date: 01 November 2024
• DOI: http://doi.org/10.1002/fut.22541

Journal of Futures Markets

RESEARCH ARTICLE OPEN ACCESS

Investor Sentiment, Unexpected Inflation, and Bitcoin

Basis Risk

Thomas Conlon

1

| Shaen Corbet

2,3

| Les Oxley

3

1

Smurfit Graduate School of Business, University College Dublin, Dublin, Ireland |

2

DCU Business School, Dublin City University, Dublin, Ireland |

3

School

of Accounting, Finance and Economics, University of Waikato, Hamilton, New Zealand

Correspondence: Thomas Conlon (conlon.thomas@ucd.ie)

Received: 22 September 2023 | Revised: 21 May 2024 | Accepted: 1 July 2024

Funding: This researchwas supported by theScience FoundationIreland under Grant Numbers16/SPP/3347 and 13/RC/2106 and 17/SP/5447 (ThomasConlon).

Keywords: Bitcoin | futures | inflation | liquidity | spot market | tail risk| volatility

ABSTRACT

The introduction of regulated CME futures contracts on Bitcoin in 2017 raised an expectation that cryptocurrencies would

become part of mainstream financial markets. This also heightened links between traditional markets and Bitcoin, implying

that the cryptocurrency would be subject to systematic spillovers. This paper uses high‐frequency data to examine whether

Bitcoin basis risk is linked to investor sentiment from established financial markets. Our findings indicate that extreme investor

sentiment, as reflected by the tail risk in various volatility indices, including the VIX, consistently correlates with a negative

Bitcoin basis, where Bitcoin futures prices are lower than spot prices. Fluctuations significantly influence this relationship in

the trading volume of Bitcoin futures and are more pronounced during periods of substantial unexpected inflation and

deflation. These results underline the complex dynamics between market sentiment and cryptocurrency pricing, offering

insights with substantial implications for investors and policymakers.

JEL Classification: G12, G14, G15, G17, G23

1 | Introduction

Launched with considerable media attention in December 2017,

the regulated CME Bitcoin futures contract was considered a

step on the road to “professionalize”the asset class.

1

The suc-

cess of this launch has been strongly debated, with some evi-

dence for subsequent downward price pressure on the spot

market (Jalan, Matkovskyy, and Urquhart 2021). The intro-

duction of the futures contract widens the opportunity set for an

investor with a negative view of an asset class to take a short

position. In a market such as Bitcoin, where taking a short

position can be expensive and cumbersome, this can result in

price mismatches between spot and futures (Gay and Jung 1999;

Fung and Draper 1999). Such mismatches give rise to basis risk,

where changes in the futures contract do not exactly offset the

spot position.

Although not producing cash flows that can be impacted by

systematic risk factors (Griffin and Shams 2020), a large liter-

ature has documented links between cryptocurrency returns

and those of traditional asset classes, especially during periods

of market‐wide volatility (Elsayed, Gozgor, and Lau 2022; Liu

and Tsyvinski 2021; Conlon, Corbet, and McGee 2021; Jo, Park,

and Shefrin 2020).

2

In contrast, using a data set that ends before

the advent of futures trading, Borri (2019) provides evidence

that cryptocurrency prices are unaffected by tail‐risk in other

asset classes. Greater market volatility has also been shown to

be associated with a transition to price discovery in the Bitcoin

futures market (Entrop, Frijns, and Seruset 2020). In the fol-

lowing research, we shed further light on these interrelation-

ships, assessing links between Bitcoin basis, trading volume,

and tail risk in several renowned volatility‐linked futures

products indicative of forward‐looking investor sentiment. Such

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided the original work is properly

cited.

© 2024 The Author(s). The Journal of Futures Markets published by Wiley Periodicals LLC.

1807 of 1831Journal of Futures Markets, 2024; 44:1807–1831

https://doi.org/10.1002/fut.22541

interlinkage would significantly support the growing maturity

of cryptocurrency products, as evidenced in the development of

related derivatives markets in recent years (Baur and

Smales 2022; Augustin, Rubtsov, and Shin 2023).

The interplay between cryptocurrency volatility, market

dynamics, and inflation highlights the complex financial profile

of assets like Bitcoin. Integrating Bitcoin into mainstream

markets introduces systemic risks that manifest through sig-

nificant energy demands impacting the energy sector during

price fluctuations (Katsiampa, Corbet, and Lucey 2019; Corbet

et al. 2020,2021). This susceptibility is further emphasized

during crises such as the COVID‐19 pandemic, where Bitcoin

experiences volatility spillovers from financial markets akin to

traditional safe‐haven assets (Corbet et al. 2020). Internally,

Bitcoin displays an asymmetric response to market shocks, a

characteristic driven by past events and news, which under-

scores the distinct behavior of cryptocurrencies in financial

markets (Katsiampa 2019a,b). This sensitivity is augmented by

the role Bitcoin plays in the interconnected network of cryp-

tocurrency returns, suggesting that external economic factors,

including Federal Open Market Committee (FOMC) an-

nouncements, significantly influence its volatility and return

dynamics (Ji et al. 2019; Chaim and Laurini 2018; Corbet,

Larkin, and Lucey 2020). Moreover, the behavior of market

participants during positive shocks illustrates how uninformed

trading can exacerbate Bitcoin's volatility, diverging from tra-

ditional financial asset behaviors and complicating its role in

the financial markets (Baur, Hong, and Lee 2018). The intro-

duction of Bitcoin futures further amplifies this volatility,

reinforcing its status as a speculative asset rather than a stable

currency (Corbet et al. 2018). Despite these challenges, Bitcoin

remains a highly investible asset, though it starkly contrasts

with traditional safe havens like gold regarding its market

reactions and liquidity (Dyhrberg, Foley, and Svec 2018;

Dyhrberg 2016; Klein, Pham Thu, and Walther 2018). The

potential of Bitcoin as a hedge against inflation is particularly

pertinent, given its capped supply and independence from

conventional monetary policies, which often lead to inflation

(Dyhrberg, Foley, and Svec 2018). Bitcoin's limited supply,

analogous to scarce resources like gold, positions it as a

potential hedge against inflation. Its effectiveness is, however,

tempered by its high volatility and the evolving regulatory

landscape, which can unpredictably influence its market value

and adoption as a mainstream investment (Dyhrberg, Foley,

and Svec 2018). These aspects underline the dual role of Bitcoin

in the financial landscape: as a speculative asset influenced by

market shocks and as a potential hedge against inflation during

economic uncertainties.

This paper investigates the intricate dynamics between Bitcoin and

established financial markets, focusing on three pivotal research

questions. First, it explores whether Bitcoin basis risk is associated

with investor sentiment as evidenced in traditional financial

markets through volatility futures tail risk while leveraging high‐

frequency data to uncover nuanced interactions. Second, the study

examines the impact of extreme market shocks on the relative

volume dynamics between Bitcoin futures and spot markets,

shedding light on more nuanced market behavior during periods

of turmoil. Finally, this research focuses on the influence of

unexpected macroeconomic news, particularly inflation, on

Bitcoin's basis and relative volume, offering insights into how

macroeconomic shocks shape market adjustments in the context

of cryptocurrency. Our research adds to the literature in various

ways. While the questions of price discovery between Bitcoin spot

and futures markets have been well assessed, there is only limited

research dedicated to understanding the basic risk between these

markets. Using high‐frequency spot and futures data to examine

links between the tail risk of volatility futures products and Bitcoin

basis and relative volume, our approach provides fresh insight into

how conventional market events can influence ostensibly inde-

pendent markets' performance.

Our analysis reveals that tail risk in various volatility futures

products, including the Chicago Board of Exchange gold vola-

tility, far‐term VIX index, and the risk reversal index, influences

Bitcoin futures pricing relative to spot prices. Specifically,

heightened tail risk correlates with a negative basis, corre-

sponding to a lower Bitcoin futures price compared to the spot

price, whereas reduced volatility aligns with higher futures

prices than the spot, as indicated by the sign on the basis

coefficient. Macroeconomic variables, particularly unexpected

inflation or deflation, significantly affect the VIX's impact on

the basis risk of Bitcoin. Our assessment extends to the second

moments of the Bitcoin basis and trading volumes, providing

robust support for our conclusions. These findings suggest

implications for policy and regulatory oversight, especially

during volatile market conditions, as they impact trading

behaviors in both regulated futures and unregulated spot Bit-

coin markets. A relative decrease in volume might point to

emerging issues, such as those instigated during the collapse of

the exchange FTX (Conlon, Corbet, and Hu 2023), which forced

many traders to seek alternative trading venues.

The remainder of the paper is structured as follows: the previous

literatureand theories that guidethe development ofour research

are summarized in Section 2.Section3presents a thorough ex-

planation of the wide variety of data used in such analysis while

presenting a concise overview of the methodologies used. Sec-

tion 4reports the empirical findings. A further brief discussion of

the theoretical and policy‐based implications of the presented

resultsisprovidedinSection5, while Section 6concludes.

2 | Previous Literature

Bitcoin futures contracts were introduced by the Chicago

Mercantile Exchange (CME) in December 2017. Despite hopes

that this would integrate Bitcoin into traditional markets, early

evidence suggested that the launch presaged an increase in spot

volatility and that futures did not provide an adequate hedging

mechanism for spot investors (Corbet et al. 2018).

3

While Bit-

coin futures hedging effectiveness is poor using the traditional

variance‐based approach, accounting for a more sophisticated

dependence structure can provide hedging benefits (Liu

et al. 2023). Assessing the impact on the moments of returns,

Jalan, Matkovskyy, and Urquhart (2021) provide evidence of

increased volatility and kurtosis of spot returns after the

introduction alongside a decrease in skewness.

The primary focus of Bitcoin futures research has been on the

price discovery mechanism with spot, with some disagreement

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