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The Pricing And Hedging Of Constant Function Market Makers

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  • Richard Dewey
  • Craig Newbold

Abstract

We investigate the most common type of blockchain-based decentralized exchange, which are known as constant function market makers (CFMMs). We examine the the market microstructure around CFMMs and present a model for valuing the liquidity provider (LP) mechanism and estimating the value of the associated derivatives. We develop a model with two types of traders that have different information and contribute methods for simulating the behavior of each trader and accounting for trade PnL. We also develop ideas around the equilibrium distribution of fair price conditional on the arrival of traders. Finally, we show how these findings might be used to think about parameters for alternative CFMMs.

Suggested Citation

  • Richard Dewey & Craig Newbold, 2023. "The Pricing And Hedging Of Constant Function Market Makers," Papers 2306.11580, arXiv.org.
    • Handle: RePEc:arx:papers:2306.11580
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    References listed on IDEAS

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    1. Guillermo Angeris & Tarun Chitra, 2020. "Improved Price Oracles: Constant Function Market Makers," Papers 2003.10001, arXiv.org, revised Jun 2020.
    2. Robin Hanson, 2007. "Logarithmic Market Scoring Rules for Modular Combinatorial Information Aggregation," Journal of Prediction Markets, University of Buckingham Press, vol. 1(1), pages 3-15, February.
    3. Alex Lipton & Artur Sepp, 2021. "Automated Market-Making for Fiat Currencies," Papers 2109.12196, arXiv.org.
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