Adaptive Market Hypothesis

We are always confused with the idea, of whether markets are efficient, i.e. it reflects all

available information onthe one hand, and on the other hand, people behave irrationally i.e

they are driven by fear and greed. Suppose, your two best friends are fighting, you would

want them to stop fighting and get along. Lo reconciled these two different approaches to

understand financial markets. So, the idea behind the Adaptive Market Hypothesis is to get

those two friends to get along and do that in a way that is intellectually satisfying.

Financial Fear Factor

There was a pilot, Robert Thompson. One day, he went to a convenience store, but as soon as

he entered the store, he turned around and left. He did this because he felt some kind of fear,

at that moment he really couldn’t tell why.But it turned out that the store was being robbed at

a gunpoint. Later, a police officer entered the store and was shot dead. Later, Thompson

realized a few details that could have triggered his fear, like a customer wearing a heavy

jacket in the extreme summer season and a car with an engine running, parked right in front

of the store. But he made his decisions unaware of his observations. This portrays that we

react much faster out of fear than our conscious mind is able to perceive. But it turns out that

the same neural circuits are often triggered when we’re threatened in other ways emotionally,

socially, and financially and therein lies the problem.

Adaptive Markets Hypothesis

It is a new way of thinking about financial markets and human behavior. The term “adaptive

markets” refers to the multiple roles that evolution plays in shaping human behavior and

financial markets, and “hypothesis” is meant to connect and contrast this framework with the
Efficient Markets Hypothesis, the theory adopted by the investment industry and most

finance academics.The Adaptive Markets Hypothesis is based on the insight that investors

and financial markets behave more like biology than physics, comprising a population of

living organisms competing to survive, not a collection of inanimate objects subject to

immutable laws of motion. It implies that the principle of evolution: competition, innovation,

and reproduction are more useful for understanding the inner working of the finance industry

than the physics-like principles of economic analysis.

Efficient Markets Hypothesis

From the adaptive market’s

perspective, the Efficient Markets Hypothesis isn’t wrong, it’s just incomplete.Markets do

look efficient under certain circumstances, namely, when investors have had a chance to

adapt to existing business conditions, and those conditions remain relatively stable over a

long period.Psychologists and behavioral economists agree that sustained emotional stress

impairs our ability to make rational decisions.Our fear makes us vulnerable in the

marketplace.That’s why we need a new, more complete framework for thinking about

financial markets, one that incorporates the fear factor as well as rational behavior.Rather

than accepting one view and rejecting the other, it’s possible to reconcile these two opposing

perspectives within a single consistent adaptive framework.

“The adaptive market hypothesis in the high frequency cryptocurrency market” by

Jeffrey Chu, Yuanyuan Zhang, Stephen Chan

For our analysis we have referred to the above paper, from which we have gathered

foundational and empirical evidence to base our analysis of Adaptive Market Hypotheses for

the cryptocurrency market.

The cryptocurrency market is a relatively new and rapidly expanding asset class that has

attracted considerable interest from investors and academics. The Adaptive Market

Hypothesis (AMH) is a framework for comprehending the dynamic character of financial

markets, and its principles are applicable to the cryptocurrency market. This paper examines

"The adaptive market hypothesis in the high frequency cryptocurrency market" by Jeffrey

Chu, Yuanyuan Zhang, and Stephen Chan to examine the AMH in the context of the high-

frequency cryptocurrency market.

The AMH proposes that financial markets are not perfectly efficient and that prices can

deviate from their fundamental values due to irrational behaviour, incomplete information,

and adaptive learning by market participants, among other factors. The AMH suggests that

market participants have varying levels of cognitive abilities, information, and processing

capacity, resulting in diverse interpretations and responses to market data. The AMH also

recognises that market conditions are dynamic and continuously changing, so market

participants' behaviour must be adaptable to these changes.

The paper by Chu et al. investigates the AMH in the context of the high-frequency

cryptocurrency market using empirical evidence. The authors analyse the trading behaviour

of market participants using data from the BitMEX cryptocurrency exchange. They observe

adaptive behaviour on the market as market participants modify their strategies in response to

shifting market conditions. The authors note that the fast adaptation phase is prevalent in the

high-frequency cryptocurrency market, where market participants respond rapidly to new

information, resulting in volatile price fluctuations.

The authors also observe a positive correlation between trading volume and volatility on the

high-frequency cryptocurrency market, consistent with the AMH's prediction that volatility

will be greater during the rapid adaptation phase. In addition, the authors discover evidence

of herding behaviour, in which market participants adopt the trading strategies of their peers.

This result is consistent with the AMH's hypothesis that market participants have varying

levels of cognitive abilities, information, and processing capacity, which leads to herding

behaviour.

The AMH has significant repercussions for investors in the high-frequency cryptocurrency

market. The volatile nature of the market necessitates that investors monitor market

conditions and adapt their investment strategies accordingly. Technical analysis can be used

to identify market trends and momentum, while behavioural finance theories can assist

investors in avoiding common decision-making errors. Furthermore, the presence of herding

behaviour suggests that investors should not uncritically adopt the trading strategies of other

market participants.

The AMH provides a framework for comprehending the dynamic nature of financial markets,

and its principles are applicable to the high-frequency cryptocurrency market. The paper by

Chu et al. provides empirical evidence of adaptive market behaviour, confirming the AMH's

predictions. The findings have significant repercussions for investors, who must monitor

market conditions and adapt their investment strategies accordingly. Focusing on adaptive

behaviour and market dynamics, the AMH can aid investors in navigating the high-frequency

cryptocurrency market.
Empirical Analysis of The High-Frequency Crypto currency Market with respect to the

Adaptive Market Hypotheses:

In this study, hourly high-frequency data

for Bitcoin and Ethereum were compared to those for the Euro and the US Dollar during July

of 2017 to September of 2018. According to the data compilation, the BTC/USD returns were

the lowest, whereas the ETH/EUR returns were the highest. Positive skewness and heavier-

than-average tails were seen in all four return series. The returns were found to be serially

correlated, non-normal, and non-stationary by statistical testing. These results suggest that

Bitcoin and Ethereum log returns in opposition to EUR and USD differ from a standard

distribution and demonstrate time-dependent characteristics, arguing for the use of flexible

market models in the study of cryptocurrencies.

The study tests the Martingale Difference Hypothesis (MDH) in economic and financial data,

specifically bitcoin returns. Popular linear tests like the Box-Pierce Portmanteau test and

Durbin-Watson test might not have potency and accuracy in due to the existence of non-linear

dependence. MDH in Bitcoin and Ethereum returns is tested using Domínguez and Lobato

(2003)'s consistent and integrated test. This test allows for non-linear dependency and

predictability from lagged data. The DL test bootstraps p-values using Cramer-von Mises and
Kolmogorov-Smirnov statistics. Due to its drawbacks, the generalized spectral (GS) test is

excluded.

The investigation explores the predictable nature of high-frequency cryptocurrency

prices/returns over time using the adaptive market theory. The study analyses July 8, 2017, to

August 31, 2018, using a rolling window with 168 previous data (seven days). Figures 1 and

2 show rolling window P-values.

Figures 1 and 2 illustrate the upturn and downturn p-values, respectively. Both figures show

Euro returns on top and US Dollar returns on bottom. Bitcoin's p-values are shown by a solid

red line, and Ethereum's by a solid blue line. The black horizontal lines denote 0.1 (dotted)

and 0.05 (solid) significance levels.

Over 14 months, p-values vary. Market efficiency fluctuates. In September 2017 and

January–May 2018, Bitcoin and Ethereum p-value movements matched. Occasionally, the

two cryptocurrencies have different trends. p-values support the adaptive market theory and

suggest external influences affect market efficiency.

Previous research also found cryptocurrency market efficiency swings. Bitcoin has alternated

between efficiency and anti-persistence, according to certain assessments. Based on past

research employing larger and narrower windows, this analysis's 168 observations are

sufficient.

Figures 1 and 2 show periods of bitcoin price inefficiency and predictability. Short-term

inefficiency is shown by p-values < 0.1 or 0.05 during each month. Bitcoin had extended

bouts of individual inefficiencies in November 2017 and April 2018. Joint inefficiency occurs

between September and December 2017.Euro and US Dollar p-values show similar trends,

although efficiency differs. Sometimes the two sets of p-values match, sometimes they don't.

The charts demonstrate Bitcoin and Ethereum

market efficiency at different times.High-frequency cryptocurrency prices show the adaptive

market theory. The p-values show external forces changing market efficiency. The findings

support earlier research on bitcoin market dynamics.

Table 3 shows the ratios of occurrences when

Bitcoin and Ethereum news items' sentiment influenced the average p-values positively or
adversely. The table shows BTC/EUR, ETH/EUR, BTC/USD, and ETH/USD ratios. The

ratios were obtained by dividing the number of news pieces with a positive or negative tone

that matched either a positive or negative shift in the average p-value by the overall number.

Table 3 shows that positive/negative news and events do not affect average p-values. Positive

news and event sentiment is more likely to cause positive average p-value changes than

negative sentiment, particularly with regard to Ethereum currency pairs.

A regression analysis of the average p-value

change and news article components is shown in Table 4. The regression model incorporates

news article sentiment and category dummy variables. The table shows the estimated

coefficients of regression for the four currency pair series.

The regression findings in Table 4 do not support the idea that good or negative news and

events influence average p-values. News that is favourable enhances average p-values and

market effectiveness only in the BTC/USD currency pair. Negative and neutral events and

news do not appear to affect any market.

News categories yield little noteworthy results. Exchange rate and technology news increases

market efficiency for the BTC/EUR currency pair. Investment news has a large negative
influence on the ETH/EUR currency pair, suggesting market inefficiencies. BTC/USD and

ETH/USD news and events have no meaningful effects.

This strategy has drawbacks. News story sentiment is interpreted subjectively. The research

also relies on major news outlets, which may miss crucial events reported by specialised

websites. Since Ethereum has fewer data points than Bitcoin, the news coverage may affect

results.

This study investigates the adaptive market hypothesis for Bitcoin and Ethereum. The

adaptive market hypothesis has never been examined at high frequency for Bitcoin and

Ethereum, although the efficient market hypothesis has.

The adaptive market hypothesis lacks a formal test procedure, in contrast to the efficient

market hypothesis. However, market effectiveness and predictable changes over time usually

support the hypothesis. The article examined the martingale difference hypothesis in Bitcoin

and Ethereum markets against the Euro and US Dollar utilising high-frequency hourly returns

to test the adaptive market hypothesis. Domínguez and Lobato (2003)'s integrated test was

used.Using a rolling window of the preceding 168 hours (7 days) of data, we analysed the

linear and non-linear dependence in the four returns series over the course of 14 months, from

July 2017 to August 2018. The tests' p-values show that all four price and return series'

dependency and predictability changed significantly during 14 months. Market efficiency

fluctuated.

The adaptive market hypothesis suggests that Bitcoin and Ethereum market efficiency

changes over time. The study also analyses cryptocurrency occurrences that occurred during

market efficiency and inefficiency. However, positive or negative news/events did not

increase market efficiency or inefficiency.

The adaptive market theory better describes market efficiency for cryptocurrencies like

Bitcoin and Ethereum than the static efficient market hypothesis. The investigation suggests

that cryptocurrency market efficiency may alter quickly. Market efficiency seems unaffected

by cryptocurrency news and mood.

In view of bitcoin trading's increasing frequency, the authors advise using higher-frequency

data in future studies. They suggest examining other market efficiency/inefficiency elements

and whether certain factors cause shorter or longer periods of efficiency. Understanding these

aspects may enhance cryptocurrency pricing and return models. Identifying when a

cryptocurrency market is likely to become inefficient and pricing more predictable could help

investors choose optimal investing times.

Andrew Lo’s views on Adaptive Market Hypotheses in relation to the cryptocurrency

market:

The Adaptive Market Hypothesis (AMH), which provides a framework for comprehending

the dynamic nature of financial markets, is proposed in "Adaptive Markets: Financial

Evolution at the Speed of Thought" by Andrew W. Lo. The AMH suggests that financial

markets are not perfectly efficient and that prices may deviate from their fundamental values

due to irrational behaviour, incomplete information, and adaptive learning by market

participants, among other factors.

The cryptocurrency market is a relatively new and rapidly expanding asset class that has

attracted considerable interest from investors and academics. The AMH can be applied to the

cryptocurrency market in order to comprehend its dynamic nature.

The extreme volatility of the cryptocurrency market is one of its defining characteristics. The

AMH suggests that volatility is greater during the phase of rapid adaptation, when market

participants react rapidly to new information. This is evident on the cryptocurrency market,

where prices can fluctuate swiftly in response to market sentiment or news events. When

Elon Musk tweeted about Bitcoin, for instance, the price of Bitcoin changed significantly and

rapidly.

Herding behaviour is another aspect of the cryptocurrency market that is consistent with the

AMH. The AMH recognises that market participants possess differing levels of cognitive

abilities, information, and processing capacity, which results in herding behaviour. This is

evident on the cryptocurrency market, where certain cryptocurrencies can experience rapid

price fluctuations when mentioned by influential individuals or the media. This indicates that

investors should not uncritically imitate the trading strategies of other market participants.

The AMH also suggests that market conditions are dynamic and constantly changing, so

market participants' behaviour must be adaptable to these alterations. This is evident on the

cryptocurrency market, where new cryptocurrencies are introduced frequently and the

regulatory landscape is still in flux. Investors in the cryptocurrency market must be cognizant

of these alterations and adjust their investment strategies accordingly.

The cryptocurrency market is pertinent to Andrew Lo's perspectives on the AMH. The AMH

principles are consistent with the dynamic nature, high volatility, and herding behaviour of
the cryptocurrency market. Investors in the cryptocurrency market must be cognizant of these

factors and adjust their investment strategies accordingly in order to successfully navigate the

market.