June 7, 2022

IRO Strategies: Intern TZ's Proxy Long/Short on $CRV Price

Dopex-EssentialsDopex-Papers
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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.
But what if I only have 4 weeks of spare time and not the 12 years required to finish his novel? Look no further, the CEO is here to save the day with another translation from the Good Book!
This article is accompanied by a BEAUTIFUL spreadsheet created by yours truly. Feel free to make a copy of it and adjust values for your own strategy.

Buying rate options as a proxy long/short on $CRV

One of the strategies mentioned by our intern is “buying rate options as a proxy long or short on $CRV”.
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Chapter 12 of 300 of TZ’s award-winning IRO novel. Please save your applause til the end.
A lot of cool words but what in Nu’s name does he mean? Allow the CEO to explain.

Rate Options

For a full explainer on IROs (Interest Rate Options), please refer to our introductory IRO article. The Most Esteemed will summarize the main points here:
  • IROs give the buyers the option, but not obligation, to receive interest based on the X rate whilst paying the Y rate.
  • For a call option, buyers can receive interest based on the floating rate whilst paying the strike rate.
  • For a put option, buyers can receive interest based on the strike rate whilst paying the strike rate
The strategy you want to implement determines whether it is a call or put option you choose to buy.
Simple stuff. Truly simple stuff.

Proxy Long/Short on $CRV

Long and Short

A long is a trading position where you think the price of an asset will go up. You purchase the asset now with the expectation that you can sell it later for a profit.
A short is a trading position where you think the price of an asset will go down. You sell the asset now with the expectation that you can repurchase it later for a discount (this typically involves borrowing the asset, selling it immediately, and repurchasing it when it decreases in price to repay your loan and profiting the difference.)

$CRV

Curve is the native token of the Curve Finance ecosystem. It is used to reward LPs for their liquidity and is typically the largest component of the APY that LPs receive. For a more indepth explainer of Curve and $CRV, refer to our Curve Explainer.

Proxy

Long and short scenarios involve directly holding or selling the asset that you wish to long or short. A proxy long/short means that you are exposed to the price action of the same underlying asset without actually holding it.
How is this possible, I hear you ask?
Well, as the price of $CRV increases, this is reflected in the APY of a Curve pool. For example, if the price of $CRV increases by 50c, this might result in an increase to the pool’s APY by 2%. This means the pool’s APY can be a proxy for the price of $CRV.
Buying an IRO allows you to earn the difference between a chosen strike price and a Curve pool’s APY. For a call, if the APY is greater than the strike price, you earn the difference between the two. This means that the Call IRO serves as a proxy for the difference between the APY and the strike price.
In a sense, our beloved intern’s strategy should really be called a proxy-proxy long/short on $CRV:
  1. Buying a call is a proxy for the Curve pool’s APY
  2. The Curve pool’s APY is a proxy for the $CRV price

The Strategy

In this explainer, we will be using a Dopex Call IRO as a proxy for longing $CRV. The same strategy can be applied to build a short position but would use Put IROs instead.
There are three things that we will need:
  1. Curve pool receiving $CRV emissions
  2. Assumptions
  3. Buy Dopex Call IROs
This example has been modeled on this cute little spreadsheet. As usual, feel free to make a copy and input your own values.
Let’s dig in, LAAADIES!

1. Curve pool receiving $CRV emissions

We will be modeling the same Curve pool as described by our lovely intern which is pictured below:
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2. Assumptions

We will also be assuming that the only input that affects the pool’s APY is the price of $CRV. The impact of $CRV price changes on APY can be seen here.
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This assumption means that variables such as gauge weight (which determines $CRV emissions allocated to the pool during the epoch), TVL, and trading fees are excluded for the purpose of this model.
Said another way, we are assuming the only variable affecting the pool’s APY is the $CRV price.

3. Buy Dopex Call IROs

Let’s see how we are able to use options to create a proxy long position.

Logic

Recall that a long position is where you expect the price of an asset to increase in value.
Rather than holding $CRV directly to benefit from a price increase, we will be buying a call option that you earn settlement revenue from if the floating rate exceeds your chosen strike rate.
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Using an initial $CRV price of $2.30, the pool will receive an APY of 11.50%.
If the price of $CRV increases to $2.70 (i.e. by 17.39%), we receive an APY of 13.50% which constitutes a 2% increase to the pool’s APY.

Buy Call Option

Using a $2.70 price target in mind, let’s move on to buying some ATM Call Options as a proxy long of $CRV price.
The Call Option will have the following factors:
  • Notional value of $100m
  • Strike Rate = Forward Rate = 11.50% (i.e. an ATM option)
  • Time to expiration of 7 days
  • Volatility of 120%
  • Discount factor of 1 (i.e. risk free rate is 0%)
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Purchasing this call option will cost $14,604.86.

Settlement Outcome

As with all option purchases, you will only earn settlement fees if the option expires ITM. Since this is a call option, the floating rate must be higher than your strike rate for your option to settle.
The net return of your option settlement less the cost of premium based on varying settlement APY’s is shown in the spreadsheet below.
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If your option expires ATM or OTM, you earn nothing from option settlement. This is the worst case scenario since your option premium is paid for no return - what we call a “sad moment” in the investment industry.
If your option expires ITM? The returns are truly incredible!
If the APY is 1% greater than your strike rate, your net return will be $4,573.22 or roughly 30% of your initial investment. This equates to a leveraged long exposure to $CRV of 3.6x given the $CRV price has only increased by 9.7%.
If the APY is 2% greater than your strike rate, your net return will be $23,761.30 or roughly 160% of your initial investment. This equates to a leveraged long exposure to $CRV of 9.35 given the $CRV price has increased by 17.39%.
This comparison is perhaps best visualized with this exquisite graph that plots the net return of a proxy long using call IROs compared to a standard 2x leveraged long depending on $CRV price!
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Good and beautiful!

Breakeven Point

This is a trading strategy that is high risk and high reward.
If your option expires worthless, you pay the option premium and receive nothing.
If it expires ITM, you are a very happy Studenteenis given the returns you receive relative to actual movement in the $CRV price.
As a prudent investor, you probably want to know what change in APY and $CRV price you would need to breakeven. Read on, students!

Breakeven APY

The king of mathematics breaks it down for you in simple terms.
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The APY required for your call option settlement to breakeven with the cost of the premium is 12.26%. This means that the APY must increase by 0.76% in this example to breakeven.
Breakeven change in $CRV Price
King of mathematics, Queen of algebra. The CEO does it again.
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Given the breakeven APY of 12.26%, the implied $CRV price required to breakeven is $2.45. Given as a percentage change compared to an initial price of $2.30, the $CRV price must increase by 6.62% to breakeven.

Parting Poem

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The father of Western philosophy and also proxy long/short strategies on $CRV price? Mr. Socrates, you are truly a class all your own.
Until next time, my loyal students.
Warm regards,
CEO (Chief Education Officer)
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Wa wa wee wa our beloved intern TZ has won the 2023 Pulitzer Prize award? Keep up the great work!

About Dopex

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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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