Epps Effect and the Signature of Short-Term Momentum Traders

Paper: arXiv 2309.06711

Authors: Jérôme Busca, Léon Thomir

Abstract

It is a well-documented fact that the correlation function of the returns on two “related” assets is generally increasing as a function of the horizon $h$ of these returns. This phenomenon, termed the Epps Effect, holds true in a wide variety of markets, and there is a large body of literature devoted to its theoretical justification. Our focus here is to describe and understand a deviation to the Epps effect, observed in the context of the foreign exchange and cryptocurrency markets. Specifically, we document a sharp local maximum of the cross-correlation function of returns on the Euro EUR/USD and Bitcoin BTC/USD pairs as a function of $h$. Our claim is that this anomaly reveals the activity of short-term momentum traders.

Complexity vs Empirical Score

• Math Complexity: 5.5/10
• Empirical Rigor: 7.0/10
• Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper presents an interesting empirical discovery by documenting a localized deviation from the classic Epps effect in FX and crypto cross-correlations. It combines sound statistical time-series analysis with a plausible behavioral market-microstructure explanation linked to short-term momentum trading.

Research Flowchart

  flowchart TD
    A["Research Question: Investigate cross-correlation anomaly (Epps Effect deviation) in FX & Crypto"] --> B["Data Inputs: High-frequency EUR/USD and BTC/USD return data"]
    B --> C["Compute Cross-Correlation Functions across varying time horizons (h)"]
    C --> D["Analyze Lead-Lag Relationships & Market Microstructure"]
    D --> E["Findings: Sharp local max in cross-correlation at short horizons reveals short-term momentum traders"]