Author: Neron

Translator: Beam,H.Forest Ventures

Derivatives have become very popular in cryptocurrencies, mainly in futures. These derivatives provide conditions for institutional investors to enter the market. They allow institutions to "hedge" themselves and reduce risk. They are therefore fundamental financial products, especially since this market is very volatile and subject to very strong trends. They can also be speculative products, but this article will not deal with that.

In this article, we will focus on a family of derivatives that is almost untapped in the crypto space, but very popular in TradFi: interest rate derivatives.

This article is not intended to be all-encompassing, nor is it intended to provide all answers to questions related to establishing such markets or liquidity. My goal is to simply illustrate some strategies that can easily protect yourself from interest rate fluctuations.

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Variable rate (purple) and fixed borrowing rates (blue) on AAVE

Interest rate derivatives are derivatives that allow you to hedge against fluctuations in interest rates, either up or down. In this article, we will discuss two main interest rate hedging tools:Swaps and options.

Unlike traditional markets, AAVE's interest rate does not depend on the price of the underlying asset, but on the availability of liquidity.

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01 Interest rate swap

An interest rate swap/interest rate swap is a two-party contract between Alice and Bob. In the case of borrowing, an interest rate swap works as follows: Suppose Alice borrows an amount X at a fixed rate, and suppose Bob borrows an amount X, but this time at a variable rate. Then, on each interest payment date, the two parties exchange the interest they must pay. So we have Alice who has chosen the fixed rate solution pays a variable rate and Bob who has chosen the variable rate option pays a fixed rate. We have an exchange of interest cash flows.

But what's the point of such a product?

Let's say I borrow $20,000 for a year from AAVE at a variable rate ranging from 0% to 20%. The corresponding fixed rate for AAVE is 10%. this means:

• If I borrow $20,000 at a variable rate, the interest I have to pay will be between 0 and 20% of the $20,000, so over a year, roughly between 0 and $4,000.

• If I borrow 20k at a fixed rate (10%), I will have to pay $2000 in interest.

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Fixed Rate (Blue)

Assume Aave borrows at a floating rate of 2% and a fixed rate of 10%. The current thinking is that interest rates will go up because a lot of people will want to borrow money. It is believed that floating rates are likely to outperform fixed rates. However, we don't know when this will happen. So we want to borrow with floating rate APR as long as it is lower than fixed rate. So we can set up a swap as follows: we borrow at a variable rate (interest rate = 2% when borrowing), and when the variable rate exceeds the fixed rate (say 10%), the interest rate swap is activated. This also means that if the floating rate never exceeds the fixed rate, the swap will never be activated.

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02 Interest rate options

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Scale on Hegic (hegic.co)

Translator's note:

Translator's note:

Cap option, which means cap option in Chinese, determines the upper limit of its interest rate cost by determining the maximum interest rate for debt instruments with variable or floating interest rates within a certain period of time in the future. It is a custom to call it Cap, because Cap means a hat, which vividly represents the upper limit of interest rates. In the same way, Floor means floor, representing the lower limit of interest rates. For the convenience of communication in the industry, neither Cap nor Floor will be translated below.

The option buyer has the right to borrow (cap rate cap) or lend (floor rate rate) a specified amount at a fixed rate for a specified period of time. Both parties agree that if there is a discrepancy between the reference rate and the rate stipulated in the contract, one party will pay the other party a premium (Premium). These contracts are usually traded on the OTC (over the counter) market. They are a tool for hedging against the risk of changes in interest rates.

Option Caps can be resold (requiring the buyer to pay the seller a premium) before the option expiration date. The same applies to Floor.

An interest rate option can be stated simply like this (for this example, Alice is the buyer and Bob is the counterparty):

Suppose Alice bought a cap option (cap) from Bob.

feature:

• Execution Rate: ETH Borrowing Rate on AAVE

• Reference rate: 5%.

If the rate of AAVE is higher than the reference fee rate (ie >5%), Bob will have to pay Alice a premium equal to the difference between tAAVE and tReference.

If AAVE rate = 10%, Bob will pay 5% to Alice.

If AAVE ratio = 4%, Bob pays nothing to Alice.

Now, suppose Alice bought a Floor from Boh.

feature:

• Exercise Rate: ETH Borrow Rate on AAVE

• Reference rate: 5%.

If the AAVE rate is lower than the reference rate (ie <5%), Bob has to pay Alice a premium (equal to the difference between tReference and tAAVE).

If AAVE rate = 7%, the counterparty will not pay Alice any premium. On the other hand, if AAVE rate = 3%, Bob will have to pay Alice a premium equivalent to 2%.

There are 3 main types of interest rate options:

Cap = call option, where the buyer decides to borrow the highest interest rate for the desired amount, and the seller takes the risk of exceeding (up) that rate (for the buyer, this is the premium payment). Therefore, the buyer must be able to borrow at a rate lower than the exercise rate for the period specified in the terms. (equivalent to a call option on interest rates).

• Contingent Cap (Contingent cap option): BorrowerHedging against rising interest rates by capping, he is not penalized for paying a premium if that hedge doesn't work for him. Contrary to the traditional Cap, the royalty payment of contingent Cap is not instant and systematic. Payment is made only when the stated interest rate is reached. Therefore, the royalty payment may only occur when the Cap is "triggered".

• Cap Spread：The buyer wants to guarantee the highest rate level, while paying a lower royalty than the classic Cap. In return, the buyer accepts that his reference rate becomes variable again from a certain rate threshold. Therefore, he benefits from the interest rate differential, which reduces his financing costs. This corresponds to buying one Cap and selling another Cap with the same option characteristics as the first Cap (amount, term, variable reference rate) but at a higher price.

• Up and Out Cap：The buyer wants to guarantee the highest interest rate level while paying a lower premium than the classic Cap. In return, the buyer accepts a hedge limited to a predetermined interest rate range. If the exercise rate exceeds the interest rate limit, the reference rate will again be variable and proportional to the exercise rate.

Floor = put option that determines at what rate one wishes to borrow money in exchange for a premium, the risk of (downward) exceeding this rate is borne by the seller. Therefore, the buyer must be able to borrow money at an interest rate higher than the exercise rate. (equivalent to an interest rate put option).

• Down And Out Floor：On the same principle as Cap Up and Out, the buyer accepts the hedge within a predetermined interest rate range. If the exercise rate exceeds the limit rate, the reference rate will again be variable and proportional to the exercise rate.

Mixed: Collar = a mix of buying Cap and selling floor or buying Floor and selling Cap.

• Corridor：Allows for the reduction or elimination of the cost of hedging borrowing by forgoing taking advantage of changes in exercise rates.

  - Debit channel:Buy CAP and sell FLOOR

  -Credit channel:Buy FLOOR and sell CAP

  In both cases, CAP and FLOOR must have the same characteristics(quantity, term, variable reference rate).

As we have seen, interest rate derivatives help control the risk of changes in interest rates. These financial instruments will eventually become commonplace. The market is currently facing several issues that prevent the development of such "institutional" tools. One example is liquidity, which is by far the biggest problem the market has had to deal with. The lack of liquidity in the market (in my opinion) is largely caused by the nature of stablecoins, which do not (yet) meet institutional standards. They are currently identified as key risks for institutions. Effective hedging to reduce the loss of anchored stablecoins is currently impossible. Once the stablecoin issue is resolved, I think the market will finally be ready to receive significant liquidity inflows. Institutional type tools are going to be very, very prominent.

Translator's note:

Translator's note:

Most of the problems in DeFi are liquidity problems, so the three carriages in the DeFi field, dex is responsible for the exchange of liquidity, Lending is responsible for the pricing of liquidity, and stablecoins are responsible for the anchoring of liquidity. The current floating-rate lending (Lending) agreement has been able to meet the market's needs for liquidity and has become the cornerstone of DeFi lending. However, for funds in the traditional financial field, fixed-rate loan products are the most basic components. Therefore, how to undertake large funds from large institutions in a simpler and more effective way to meet their needs for fixed costs and fixed income and break through the existing DeFi The ceiling of field development may be the direction of exploration for a long time in the future.