May 27, 2022

IRO Strategies: Intern TZ Fixes Interest Rates

Between coffee runs, foot massages, and letter opening, it may come to everyone’s surprise that our intern TZ is a budding young novelist. Years of penning away have culminated in a literary masterpiece rivaling the works of J.R.R. Tolkien and George R.R. Martin in both quality and length. This article will be the first in a series of short stories that break down TZ’s novel into manageable chunks.

Using Calls and Puts to fix your so-called “Rates”

One of the strategies mentioned by our intern is “writing ATM calls or buying puts at a rate they’re happy receiving”.
Chapter 45 of 300 of TZ’s IRO novel
This article will assume you have a general understanding of how Curve and Dopex’s Interest Rate Options (IROs). Follow the links below to get a simple overview:

The Basics

Curve Finance is a decentralized exchange (DEX) that allows users to provide liquidity that enable traders to conduct high volume low-slippage transactions on pegged assets, most typically stablecoins. Liquidity providers (LPs) generate income from transaction fees as well as $CRV emissions.
These $CRV emissions are determined by a pool’s gauge weight. The more veCRV votes allocated to a pool, the more $CRV emissions that the pool receives. There are a lot of variables that could determine an LPs return including:
  1. $CRV price
  2. Gauge weight to pool
  3. TVL of pool
  4. Trading volume in the pool
The interplay of these factors makes the actual APY received by LPs highly variable. For investors that like consistency, this volatility might not be ideal.

The Dopex Tie-In

The introduction of Dopex’s IROs gives LPs the opportunity to fix their rates. As a reminder, IROs can either be:
  1. Call Options: Gives the buyer the right, but not the obligation, to receive the floating rate and pay the strike rate.
  2. Put Options: Gives the buyer the right, but not the obligation, to receive the strike rate and pay the floating rate.
There are two possible solutions that involve either writing a call option or buying a put option to accompany an investor’s LP position.
By buying a put, an investor can ‘lock-in’ a minimum APY for their pool. The put they purchase will have the same notional value as their LP amount. They would receive the floating rate from their LP whilst they would receive the strike rate and pay the floating rate from their put option settlement if it expires ITM. These two transactions net out so the investor ends up receiving the strike rate less the option premium. This strategy is highly effective if you want to establish a minimum APY.
Alternatively, an investor can ‘lock-in’ a maximum APY for their pool. They would write a call option with the same notional value as their LP amount. If the call expires ITM, they would pay the floating rate from their LP whilst minus the difference between the floating rate and the strike rate. This strategy is effective if you think you the APY will be relatively stable since you will always earn the option premium.

The Strategy

Let’s go through a worked example to see how all these pieces fit together. This section will be accompanied by this incredible spreadsheet - as usual, you can make a copy and input variables that fit your own strategy.

1. LP on Curve

The first step of this strategy is to LP on Curve. Without this, what APY are you even trying to fix, you silly bean?
Pictured below is the two week return an LPer would expect given varying APY’s:
Good, sexy, beautiful.

2. Fixing Rates with Options

Now that you have successfully LPed, it is time to fix those rates. This strategy will use ATM options only.
In our following two examples, let’s pretend:
  • The notional value of your option is $1m (equal to your LP amount)
  • Current floating rate (APY) is 4%
  • Strike rate is 4%
  • Term is 14 days
  • Volatility is 120%
  • Risk-free rate is 0%
Inputting the above will give you cost/revenue from option premiums for both calls and puts as $143.52

A) Write a Call IRO

A Call IRO expires ITM if the floating rate is greater than the fixed, with the option writer paying the difference at settlement to the option buyer. Alternatively, if the fixed rate (strike) is greater than the floating rate the position is OTM and the contract is not executed. Regardless of how the option settles, the writer will receive $143.52.
Writing a call option fixes the upper side of your APY to your chosen strike rate. This strategy is good if you believe that the APY will be stable (i.e. current floating rate = floating rate at settlement) or the APY will decrease as the option will expire OTM and you will still earn the option premium.
A comparison of returns of the above strategy versus LPing alone can be seen in the chart below.
If the strike rate is higher than the floating rate, your return will be higher due to the option premium. However, if the settlement APY is greater than the strike rate your return may end up being less than LPing alone.

B) Buy a Put IRO

As a Put IRO buyer, the option expires ITM if the strike rate is higher than the floating rate. By LPing an equal amount ($1m in this example) to the notional value of the option that you purchase, you can fix the lower side APY of your chosen Curve pool.
In the above example, the net return is fixed at 4% APY which is your chosen strike rate. If the APY decreases to 2%, your return on Curve decreases but this amount is exactly offset by the option settlement amount to bring your net return (before premium) to the return you would have received if the Curve APY was actually 4%. For LPers that want stable returns, this is a very powerful tool to lock in a minimum APY that you are happy with.
To look a little deeper, let’s review the formulas and see what they net out at:
Return from Curve LP: LP amount * Floating Rate * Term
Return from buying Put IRO: Notional value * (Strike Rate - Floating Rate) * Term
Since we are LPing the same amount as the notional value of the put IROs we are purchasing, we can treat LP amount and Notional value to be equal. When we sum these two equations together and expand brackets, the net amount we receive should be:
Net Return: Notional Value * Strike Rate * Term
Locked and loaded, as simple as that.
A comparison of returns of the above strategy versus LPing alone can be seen in the chart below.
If APY ends up being less than your strike rate, your option will pay out. Since you are required to pay an option premium for this, if the APY exceeds your chosen strike rate, your final return will be lower than LPing alone.
Parting Poem
Philosopher, polymath, DeFi native. What can’t you do, my dear Aristotle.
Until next time my loyal students.
Warm regards,
CEO (Chief Education Officer)

In this moment I am euphoric not because of the blessing of some phony god but because I am enlightened by my own intelligence.

About Dopex

Dopex is a decentralized options protocol that aims to maximize liquidity, minimize losses for option writers and maximize gains for option buyers — all in a passive manner.
Dopex uses option pools to allow anyone to earn a yield passively. Offering value to both option sellers and buyers by ensuring fair and optimized option prices across all strike prices and expiries. This is thanks to our own innovative and state-of-the-art option pricing model that replicates volatility smiles.

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