AP-Why?

Introduction

In this blog post, we will be discussing Cega’s yield and exploring how it is calculated. We will delve into the various factors that impact yield, as well as the risks associated with obtaining yield. Additionally, we will explore why yields for exotic options tend to be better than those for vanilla options and examine the sources of yield. By the end of this blog post, readers can expect to have a better understanding of Cega yield and the various factors that impact it.

How is Cega yield generated and what does the APY mean?

Users depositing into Cega vaults generate yield by receiving the premium paid by buyers of the option. These buyers in Web3 are often market makers (MM) who tend to be large financial institutions or professional traders that act as intermediaries between buyers and sellers of securities. MMs buy options as a way to hedge their portfolios against potential losses, akin to buying insurance against severe market downturns. For example, if a market maker holds a large number of shares in a cryptoasset and is concerned about the possibility of a downward price movement, they may purchase a put option as a hedge. If the cryptoasset’s price does drop, the market maker can sell the underlying assets at the strike price, limiting their losses. The premium paid for the put option is the yield in this scenario. Recall that Cega’s vault options expire after 27 days. This means that MMs who want continued “insurance” will buy another 27 day Cega vault trade. This generates the source of continual options premium for Cega vault depositors.

As a refresher, an option is a financial contract that gives its buyer the right, but not the obligation, to buy or sell an underlying asset, such as a stock or crypto asset, at a specified price (strike price) within a specified time period. When a market maker buys an option, they must pay a fair amount of money (called the “premium”) to the seller of the option. This premium is the source of the yield in options trading and provides the real yield for Cega vaults.

Yield is often expressed by MMs as annualized value called the APR, “Annual Percentage Rate”. It is calculated by taking (1) the dollar value of the coupons (i.e. options premium paid to vault users) over 27 days, (2) dividing by the initial investment notional amount, and (3) annualizing the percentage (meaning multiplying by approximately 12). Because Cega vaults create compounded returns by rolling over users’ yield and initial investment from month to month, the APY is calculated from the APR to reflect the compounded returns after one year.

What are the factors that impact yield?

The yield of exotic options can be impacted by several factors, including:

1. Volatility: The level of volatility in the market also affects the yield of exotic options. Options on assets that are more volatile tend to have higher premiums and yields, as the buyer of the option is willing to pay more for the right to buy or sell an underlying asset at a specified price in a potentially volatile market.
2. Strike price: The strike price of the option also affects the yield. Options with strike prices that are closer to current asset prices tend to have higher premiums and therefore, higher yields. This is because options with higher strike prices are considered to be more likely to be exercised, and as a result, the seller of the option is able to charge a higher premium.
3. Expiration date: The expiration date of the option also impacts the yield. Options that expire sooner tend to have lower premiums and therefore, lower yields, while options with longer expiration dates tend to have higher premiums and yields. This is because options with longer expiration dates provide the buyer with more time to realize a profit, and as a result, the seller of the option can charge a higher premium.
4. Expiration exotic features: The expiration date of an exotic option can be complex itself. For example an exotic option can give the opportunity to exercise at any time and date before expiry whereas its distant relative, the vanilla option, can only be exercised once at expiry, making it less expensive and hence providing less chance for high yield.
5. Complexity of the underlying basket: The more complex the underlying basket is, the more potential for volatility it has, and the higher the yield. For example, an option on the worst performer of a basket will tend to be more volatile that an option on the average of a basket, hence providing more yield.
6. Credit risk: The risk that a borrower may default on a loan or debt, which can affect the lender’s expected rate of return. Generally, lenders demand a higher APY for higher credit risk borrowers to compensate for the additional risk of default. However, the products offered by Cega do not involve any credit risk from bonds in the structure.

In conclusion, the yield of exotic options can be impacted by a variety of factors, including the complexity of the underlying basket, the strike price, expiration date and features around observation dates and volatility. It’s important for traders and investors to carefully consider these factors when evaluating the yield of exotic options.

Why are yields for Cega exotic options better than vanilla options?

Exotic options generally offer higher yields compared to vanilla options, because they combine multiple layers of yield generating features that vanilla options alone cannot provide.

Exotic options are a type of derivative that are more complex and customized than vanilla options. They are typically tailored to meet the specific needs of a particular trader or investor and can involve complex underlying assets, unusual strike prices, or unusual expiration dates. The increased complexity of exotic options can lead to higher premiums, and therefore, higher yields for the seller of the option.

Additionally, exotic options often have more tailor made risk-reward profiles compared to vanilla options. For example, barrier options provide protection against adverse price movements by setting a “barrier” price that, only if breached, activates the option and affects principal, whereas the non exotic version started losing earlier and in more scenarios. This added layer of protection can make the option less risky and more attractive to investors.

In summary, exotic options can offer higher yields compared to vanilla options, but this comes with increased complexity and risk. It’s important for traders and investors to carefully consider their risk tolerance and investment goals before investing in exotic options.

What are the risks associated with getting yield?

The risks associated with obtaining yield from exotic options include:

1. Counterparty risk: Exotic options are often traded over-the-counter (OTC), meaning that they are not traded on a regulated exchange. As a result, there is a risk that the counterparty to the trade may not fulfill their obligations under the contract. Cega vaults do not lend user funds out so counterparty risk does not apply to the principal. It does apply to the coupon owed to users upon expiry of a trade, if a counterparty were to not pay.
2. Complexity: The complexity of exotic options makes it more difficult to accurately price the option, and the underlying asset. This can result in an incorrect evaluation of the risk involved in the trade, and a higher risk of loss.
3. Market liquidity: The market for exotic options can be less liquid than the market for more commonly traded options, making it more difficult to sell the option when needed. This can result in a lower yield, or a higher risk of loss, as the seller may be unable to sell the option at a favorable price.
4. Market volatility: Exotic options are often traded in markets that are more volatile, which can result in sudden and significant price movements. This can result in a higher risk of loss for the seller of the option, as the buyer may exercise the option when the underlying asset is trading at a price that is unfavorable to the seller.

The yield from exotic options can come with risks, including counterparty risk, complexity, market liquidity and volatility. It’s important for traders and investors to carefully consider these risks before investing in exotic options.

Conclusion

In conclusion, Cega vaults offer users the opportunity to generate yield by depositing their assets and selling options to market makers. The premiums paid by market makers for these options provide the source of yield for vault users, with the APR and APY calculated based on this premium. Cega exotic options vaults can provide higher yields and more tailored risk-reward profiles, making them an attractive option for experienced traders and investors. However, their increased complexity and customized nature also make them more risky and suitable for investors with a higher risk tolerance.