Model-Free Hedging of Impermanent Loss in Geometric Mean Market Makers
21 Pages Posted: 4 Apr 2023
Date Written: March 23, 2023
We consider Geometric Mean Market Makers – a special type of Decentralized Exchange – with two types of users: liquidity takers and arbitrageurs. Liquidity takers trade at prices that can create arbitrage opportunities, while arbitrageurs align the exchange’s price with the external market price. We show that in Geometric Mean Market Makers charging proportional transaction fees, Impermanent Loss can be super-hedged by a model-free rebalancing strategy. Moreover, we demonstrate that in such a DEX, the exchange rate is of finite variation, so that loss-versus rebalancing (the shortfall of providing liquidity versus the corresponding constant-weights portfolio) vanishes.
Keywords: digital currencies, automated market makers, Impermanent Loss, decentralized exchanges, divergence loss
JEL Classification: D47, D53, C02
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