<aside> 💡 Interest rate swaps are well stablished fixed income contracts in traditional finance. However, many of the traditionally trivial steps when pricing interest rate swaps are extremely hard in the context of Decentralized Finance (DeFi).
In this paper we propose a method to estimate the one, two and three months interest rates in the DeFi credit markets.
We also propose a method to price interest rates swaps on a basket of interest rate bearing protocols on DeFi.
Finally, we propose a computationally inexpensive approximation in order to deploy the pricing mechanism to the blockchain.
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Keywords: DeFi, Interest Rate Swaps, Dynamic Programming, Quantitative finance
What is the price of an interest rate swap in a Decentralized Finance (DeFi) protocol?
Interest rate swaps are well stablished fixed income contracts in traditional finance since at least the 80's. At the same time, pricing of such contracts are also well understood in the context of traditional finance.
However, many of the traditionally trivial steps when pricing interest rate swaps are extremely hard in the context of Decentralized Finance. Two of the main issues in this context is the lack of market data to properly bootstrap a yield curve and the limited computational resources of a blockchain. For some of the challenges when pricing interest rates swaps on chain see [Zhao et al.] or [Voltz Protocol], and see [Aldweesh et al.] for a discussion on the limitations of computations on a blockchain.
This paper is structured as follows: In section 1 (Pricing Strategy) we define the problem we are trying to solve. In this section we define the idea of the fair pricing of interest rates swaps versus the portfolio exposure. In section 2 (The shape of the model) we define the model we will calibrate against the historical data to estimate the one month interest rate. The model in this section is a combined clustering step with a series of linear models per cluster. In section 3 (Yield Curve) we study the historical observed yield curve and we construct a probability distribution for the two and three months interest rate. Section 4 (Risk Management) we describe our findings from our multi-agent simulation, including recommendations for parameter fine-tuning.
Our contribution described in this paper is three-folded:
We propose a construction of the yield curve in DeFi markets bootstraping from historical data.
In this paper we are proposing a mechanism for the fair pricing of interest rate swaps on DeFi credit markets.
Finally, we build a risk framework on top of the IPOR rate for simplicity, but the methods in these notes should be adaptable to other rates and markets.
IPOR Rate: The IPOR rate is an aggregate index of multiple money market protocols. It is equivalent to the mid market rate (borrow-lend mid market) weighted by Total Value Locked (TVL). For more details on IPOR rate see: IPOR Index - The Heartbeat of DeFi
Interest Rate Swaps (IRS): Interest Rate Swaps are contracts between two parties where one party agrees in paying a fixed rate cashflow (agreed at the start of the contract), while the other party agrees in paying the floating rate cashflow (an index rate with its value unknown at the start of the contract). For more details on IRS see: