Static Replication of Impermanent Loss for Concentrated Liquidity Provision in Decentralised Markets

TL;DR

This paper develops static replication formulas to accurately estimate impermanent loss in concentrated liquidity pools, enabling liquidity providers to hedge losses using centralized crypto options markets.

Contribution

It introduces two novel static replication formulas for impermanent loss, bridging decentralized liquidity provision with centralized options trading for effective hedging.

Findings

Static replication formulas accurately estimate impermanent loss.

Hedging strategies using centralized options are feasible and effective.

Numerical examples demonstrate high accuracy of the proposed formulas.

Abstract

This article analytically characterizes the impermanent loss of concentrated liquidity provision for automatic market makers in decentralised markets such as Uniswap. We propose two static replication formulas for the impermanent loss by a combination of European calls or puts with strike prices supported on the liquidity provision price interval. It facilitates liquidity providers to hedge permanent loss by trading crypto options in more liquid centralised exchanges such as Deribit. Numerical examples illustrate the astonishing accuracy of the static replication.