All About Yield — Fair Pricing for Zero-Liquidation Loans
Exploring how to find the fair value and yield of ZLLs and considerations for pricing loans based on risk appetite
The MYSO v2 testnet is currently live here: https://testnet.myso.finance/
We’ve made a massive leap in terms of capital efficiency, scalability, ease-of-use, and flexibility with the MYSO v2 protocol. Zero-Liquidation Loans have been upgraded for borrowers to greatly extend the potential of their on-chain strategies and for eager lenders to tap into a million ways to structure their yield.
We recently explored the topic of optionality as a mechanism underlying Zero-Liquidation Loans and subsequent payoffs for lenders that take on the role as underwriters. Expected payoff and yield for lenders will fluctuate based on how loan terms are structured and ensuing market conditions, so it’s important for lenders to understand how to properly price their Zero-Liquidation Loans so that they are compensated fairly for the expected risk/reward.
With that being said, let’s dive into how lenders can come to a “fair value” for the Zero-Liquidation Loan they plan to underwrite and figure out a framework for understanding the underlying pricing logic 👇
Pricing Zero-Liquidation Loans
At inception, a Zero-Liquidation Loan on MYSO v2 can be seen as a swap, where the borrower pledges some collateral for which they then receive a loan amount plus an embedded call option. As discussed in the previous Medium piece, lenders sell a call option to the borrower that accepts their given loan quote which gives the borrower the right, but not the obligation, to reclaim their collateral prior to some expiry date. Now, to fairly price this ZLL, we need to determine a fair value for that embedded call option.
It’s important to note that it is solely up to lenders to set the terms for the loans they underwrite. However, to make things appealing for a potential borrower, it is suggested to price each ZLL such that neither party is better or worse of at inception. Of course, this is mainly applicable for the rational and like-minded borrower, so arbitrations will always exist for users to capitalize on.
To understand how to fairly price a ZLL, let’s visualize a theoretical loan: Assume a borrower has arrived on MYSO v2 and wants to take on a loan and borrow $1500 worth of USDC against their ETH collateral worth $2000 for 90 days (75% LTV).
Now, to make the swap fair, the borrower should receive a call option which is worth $500 because this way the position value pre- and post- borrow is the same. In this situation, how should a lender choose the strike price of the embedded call option such that its fair value is $500, and how will the prospective yield be determined?
The most simple and widely-used method for pricing an option is to use the Black-Scholes pricing model, which takes into account several factors, including the current price of the collateral, the risk-free rate, price volatility of the collateral, the loan tenor, and the strike price. Other models and pricing methodologies are also available, so it’s up to market participants to decide how they want to go about pricing these embedded options to come to a fair loan valuation.
Under Black-Scholes assumptions, let’s again point out that 1 ETH is worth $2000 and you want to buy a European call option with a loan tenor of 90 days, where ETH volatility is at ~80% and the theoretical risk-free rate is 4%. For the value of the call option to come out to be $500, the strike price would have to be ~$1661.
So, if we were to swap 1 ETH worth $2000 to receive a loan of $1500, as well as this call option worth $500, the strike for this option would be ~$1661 and we would have a situation where the position is fairly priced with no party better or worse off.
Let’s consider the above example and translate it into an APR — if a borrower takes the $1500 loan and ends up repaying the $1661 strike price to reclaim their collateral prior to expiry (90 days), the implied APR would be 42.9% — this means that the term rate, or rate adjust for the loan period, would be around ~10.73%.
Visualizing APR differences
Let’s take a look at how different loan tenor/LTV combinations affect fair strike prices and implied APRs given that a borrower puts up 1 ETH (= $2000) with 80% implied volatility.
You can see how Black-Scholes-derived fair APRs do increase for higher tenor/LTV combinations, which intuitively makes sense as lenders bear more duration risk and hence expect to receive a higher APR to be compensated for this.
Implied volatility also has a profound effect on the fair pricing of a ZLL —if we increase the volatility of ETH to 100% rather than 80%, we can see higher APRs for the same tenor/LTV combinations as well more pronounced variations across the same combinations.
It is important to consider that although the Black-Sholes pricing model is a nifty tool for fair-strike option pricing, the underlying option logic on MYSO is akin to American option expiries rather than European options, meaning that the option can be exercised (underlying collateral can be reclaimed) at any time prior to expiry rather than only at the expiration date. Since the underlying smart contracts are oblivious towards the pricing of these options, market participants are able to benefit from loan fair-value mispricing and non-linear risk transferal through the use of Black-Scholes or other option pricing models. This means that there will also be opportunities for both counterparties to capture fair-value arbs on mispriced loans!
If you’d like to tinker with various loan parameter combinations and figure out prospective yield, we’ve put together an interactive Zero-Liquidation Loan Pricer for you to utilize:
https://mysofinance.streamlit.app/
You can input various volatility/risk-free rate selections as well as your desired LTV/tenor combinations to print APR/upfront fee heatmaps that show the prospective yield for your loans!
Ramping up for v2 launch
At MYSO, we’re convinced that designing oracle-independent, liquidation-free lending systems will change the landscape of the current DeFi status quo.
MYSO v2 gives full control of loan structuring to users, allowing for more flexible, customizable loans that can fit anyone’s risk appetite. This is done through the embedded optionality inherent to all Zero-Liquidation Loans and lets user decide what sort of risk/reward structure they want to take on. By providing an avenue to do so, we can work towards a future that gives users more control over their loans in a permissionless and truly decentralized manner.
Please reach out on Discord if you have any questions and feel free to try out the script we’ve prepared above to test out yield opportunities for different collateral/loan currency combinations!
We’re excited to get v2 launched on Ethereum and Mantle mainnet in the coming weeks — stay tuned 👀
