The Quantitative Finance Aspects of Automated Market Markers in DeFi

TL;DR

This paper reviews the mathematical and financial principles behind Automated Market Makers in DeFi, highlighting their connection to derivatives pricing and hedging, based on existing literature.

Contribution

It provides a comprehensive synthesis of the quantitative finance concepts underlying AMMs, emphasizing their relation to derivatives and market dynamics.

Findings

AMMs can be modeled using derivatives pricing frameworks

The paper identifies key mathematical relationships in AMM operations

Insights into hedging strategies in DeFi markets

Abstract

Automated Market Makers (AMMs) are a class of smart contracts on Ethereum and other blockchains that "make markets" autonomously. In other words, AMMs stand ready to trade with other market participants that interact with them, at the conditions determined by the AMM. In this this paper, which relies on the existing and growing corpus of literature available, we review and present the key mathematical and quantitative finance aspects that underpin their operations, including the interesting relationship between AMMs and derivatives pricing and hedging.