Split the Yield, Share the Risk: Pricing, Hedging and Fixed rates in DeFi

TL;DR

This paper develops a formal framework for yield tokenization in DeFi, enabling risk transfer, hedging, and fixed-rate lending through novel pricing models, automated market makers, and interest rate discovery mechanisms.

Contribution

It introduces the first formal model for yield token dynamics, no-arbitrage pricing, and a modular fixed-rate lending protocol in DeFi.

Findings

Yield tokens facilitate risk transfer and hedging in DeFi.

Automated market makers with bonding curves improve liquidity and trading efficiency.

The proposed fixed-rate lending protocol enhances capital efficiency and interest rate discovery.

Abstract

We present the first formal treatment of \emph{yield tokenization}, a mechanism that decomposes yield-bearing assets into principal and yield components to facilitate risk transfer and price discovery in decentralized finance (DeFi). We propose a model that characterizes yield token dynamics using stochastic differential equations. We derive a no-arbitrage pricing framework for yield tokens, enabling their use in hedging future yield volatility and managing interest rate risk in decentralized lending pools. Taking DeFi lending as our focus, we show how both borrowers and lenders can use yield tokens to achieve optimal hedging outcomes and mitigate exposure to adversarial interest rate manipulation. Furthermore, we design automated market makers (AMMs) that incorporate a menu of bonding curves to aggregate liquidity from participants with heterogeneous risk preferences. This leads to an efficient and incentive-compatible mechanism for trading yield tokens and yield futures. Building on these foundations, we propose a modular \textit{fixed-rate} lending protocol that synthesizes on-chain yield token markets and lending pools, enabling robust interest rate discovery and enhancing capital efficiency. Our work provides the theoretical underpinnings for risk management and fixed-income infrastructure in DeFi, offering practical mechanisms for stable and sustainable yield markets.