Potion Insurance: Black Scholes Model
Black Scholes model
In 1973, Fischer Black and Myron Scholes developed a mathematical approach to pricing options on the basis of “risk-neutrality” for both buyers and sellers. In 1997 they would go on to win the Nobel prize in Economic Sciences for this contribution.
Here are the mechanics of the Black Scholes model:
As you can see, volatility is one of the inputs to the model. Intuitively, the price of insurance should be higher, the higher the uncertainty about the future. This uncertainty is often expressed as “volatility”.
Issues with the Black-Scholes approach
Here’s the catch with the BS-Model: at the time of pricing the option contract, parties can only check “historical volatility”, which may be very different to the actual volatility that will take place during the life of the contract.
In practice, this means option sellers and buyers must “guess” what volatility may materialize in the future, and price their contracts accordingly. This volatility guess is called “implied volatility” — the market expressed sentiment of what volatility will be in the future.
Potion’s solution to the implied volatility problem
Potion’s pricing system removes the need to “guess” what volatility will be — instead, it only fully settles the price of the premium at liquidation, on the basis of actual observed volatility (also referred to as realized volatility).
Here’s the process
- At creation: When the insurance is sold for the first time, buyer submits a “deposit” for the premium. This deposit is calculated such that it covers the worst volatility ever observed for the asset, plus a safety buffer.
- At liquidation: When the insurance is exercised/liquidated, the Black-Scholes model is used to calculate the risk-neutral price that buyer/seller should have agreed. REALIZED VOLATILITY is used as an input to the model during the life of the contract, as opposed to implied volatility.
Benefits of deterministic pricing
- Better for the potion insurance seller (LPs): If unexpected volatility spikes take place, sellers will be compensated for it, even if that couldn’t have been predicted up-front.
- Better for the potion insurance buyer: buyers should expect lower fees than using implied volatility.
- Better for robo-strategy engines: other DeFi legos can be built of top of Potion, and benefit from predictable prices. Potion’s deterministic pricing allows for robust backtesting of robo strategies, making it a clear choice to deploy strategies to.
Using Black-Scholes “after the fact”, means both parties get fairest possible premium — we call this perfect pricing 👌.
Read more:
- hackmoney submit: Potion Insurance
- Potion Insurance: Design
