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DeFi Arbitrage in Hedged Liquidity Tokens

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  • Maxim Bichuch
  • Zachary Feinstein

Abstract

Empirically, the prevailing market prices for liquidity tokens of the constant product market maker (CPMM) -- as offered in practice by companies such as Uniswap -- readily permit arbitrage opportunities by delta hedging the risk of the position. Herein, we investigate this arbitrage opportunity by treating the liquidity token as a derivative position in the prices of the underlying assets for the CPMM. In doing so, not dissimilar to the Black-Scholes result, we deduce risk-neutral pricing and hedging formulas for these liquidity tokens. Furthermore, with our novel pricing formula, we construct a method to calibrate a volatility to data which provides an updated (non-market) price which would not permit arbitrage if quoted by the CPMM. We conclude with a discussion of novel AMM designs which would bring the pricing of liquidity tokens into the modern financial era.

Suggested Citation

  • Maxim Bichuch & Zachary Feinstein, 2024. "DeFi Arbitrage in Hedged Liquidity Tokens," Papers 2409.11339, arXiv.org.
  • Handle: RePEc:arx:papers:2409.11339
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    References listed on IDEAS

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    1. Wood, Robert A & McInish, Thomas H & Ord, J Keith, 1985. "An Investigation of Transactions Data for NYSE Stocks," Journal of Finance, American Finance Association, vol. 40(3), pages 723-739, July.
    2. Masaaki Fukasawa & Basile Maire & Marcus Wunsch, 2023. "Weighted variance swaps hedge against impermanent loss," Quantitative Finance, Taylor & Francis Journals, vol. 23(6), pages 901-911, June.
    3. Jin Hong Kuan, 2022. "Liquidity Provision Payoff on Automated Market Makers," Papers 2209.01653, arXiv.org.
    4. Álvaro Cartea & Fayçal Drissi & Marcello Monga, 2023. "Predictable Losses of Liquidity Provision in Constant Function Markets and Concentrated Liquidity Markets," Applied Mathematical Finance, Taylor & Francis Journals, vol. 30(2), pages 69-93, March.
    5. Stefan Loesch & Nate Hindman & Mark B Richardson & Nicholas Welch, 2021. "Impermanent Loss in Uniswap v3," Papers 2111.09192, arXiv.org.
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