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Replicating Portfolios: Constructing Permissionless Derivatives


  • Estelle Sterrett
  • Waylon Jepsen
  • Evan Kim


The current design space of derivatives in Decentralized Finance (DeFi) relies heavily on oracle systems. Replicating market makers (RMMs) provide a mechanism for converting specific payoff functions to an associated Constant Function Market Makers (CFMMs). We leverage RMMs to replicate the approximate payoff of a Black-Scholes covered call option. RMM-01 is the first implementation of an on-chain expiring option mechanism that relies on arbitrage rather than an external oracle for price. We provide frameworks for derivative instruments and structured products achievable on-chain without relying on oracles. We construct long and binary options and briefly discuss perpetual covered call strategies commonly referred to as "theta vaults." Moreover, we introduce a procedure to eliminate liquidation risk in lending markets. The results suggest that CFMMs are essential for structured product design with minimized trust dependencies.

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  • Estelle Sterrett & Waylon Jepsen & Evan Kim, 2022. "Replicating Portfolios: Constructing Permissionless Derivatives," Papers 2205.09890,, revised Jun 2022.
  • Handle: RePEc:arx:papers:2205.09890

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    References listed on IDEAS

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    4. Peter Carr & Katrina Ellis & Vishal Gupta, 1999. "Static Hedging Of Exotic Options," World Scientific Book Chapters, in: Marco Avellaneda (ed.), Quantitative Analysis In Financial Markets Collected Papers of the New York University Mathematical Finance Seminar, chapter 5, pages 152-176, World Scientific Publishing Co. Pte. Ltd..
    5. Tashjian, Elizabeth, 1995. "Optimal futures contract design," The Quarterly Review of Economics and Finance, Elsevier, vol. 35(2), pages 153-162.
    6. Daniel Perez & Sam M. Werner & Jiahua Xu & Benjamin Livshits, 2020. "Liquidations: DeFi on a Knife-edge," Papers 2009.13235,, revised Dec 2021.
    7. Goldman, M Barry & Sosin, Howard B & Gatto, Mary Ann, 1979. "Path Dependent Options: "Buy at the Low, Sell at the High"," Journal of Finance, American Finance Association, vol. 34(5), pages 1111-1127, December.
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