Financial derivatives

BOND token markets can be used in DGF to create contracts with payout schemes which mimic the functionality of the legacy financial tools called derivatives, i.e., various types of call and put options.

For instance a basic BOND already has some of the properties of a call option, since it serves as a claim on the future DAO earnings, through the REP salary. If the value of the DAO goes up, that typically means the REP salary goes up, which means the BOND increases in value.

More complicated smart contract designs allow us to capture more of the properties of traditional options. After discussing the basic design, we explore the value that insurance can bring to the derivatives market, making it more liquid.

PUT-CALL options

We detail the design of two basic financial derivatives. PUT-CALL options and CALL-PUT options. The names indicate the partly symmetric function of these financial tools. The reason for the name is that inorder for one party to buy a put, a counterparty must buy a call.

A PUT-CALL option on a DAO can be designed using a smart contract to limit the liability of the PUT buyer with the following design. Two parties encumber money in a PUT-CALL smart contract. The two parties are called the PUT buyer (whom we think of as the buyer of a traditional put option) and the CALL buyer.

The PUT-CALL smart contract design is then given by the following basic flow:

1. The CALL buyer encumbers $\$P_{0}$ cash in the contract.
2. The PUT buyer encumbers $\$U>\$P_{0}$ cash in the contract. (Here $\$(U-P_{0})$ represents the maximum amount the PUT buyer is willing to lose if the price of BONDs goes up instead of down. This is similar to the premium in a traditional put.)
3. The PUT-CALL smart contract initates at time $t=0$ and matures at time $t=T$.
4. At maturity time $T$, the PUT-CALL smart contract checks to see if the PUT buyer has encumbered a BOND token in the contract.
   • If the price of a BOND has gone up beyond $\$P_{0}$, the rational PUT buyer does not encumber the BOND at maturity time. So if the BOND is not encumbered, the contract gives $$U$ to the CALL buyer and gives $\$P_{0}$ to the PUT buyer. (So the PUT buyer loses $\$(U-P_{0})$, which the CALL buyer wins.)
   • If the price of a BOND has gone down below $\$P_{0}$, the rational PUT buyer buys a BOND at market for $\$B_{T}$ and encumbers the BOND before maturity time. Then the contract gives the BOND to the CALL buyer, and $\$(U+P_{0})$ to the PUT buyer. (So the PUT buyer gains $\$(P_{0}-B_{T})$.)

A PUT-CALL option gives priority to the PUT buyer, as they can profit any amount up to $\$P_{0}$ if the BOND value collapses to $0, and the PUT buyer has limited liability of $\$(U-P_{0})$ in case the BOND token's value explodes.

$\$P_{0}$ may be thought of as representing the current market price of a BOND at initiation, though market prices are a fiction. So $\$P_{0}$ can be thought of as the strike price of the option for the PUT buyer. $\$P_{0}$ will typically be below the price $\$B_{0}$ that a BOND buyer can get at market when the contract initiates, in order for the PUT buyer to entice the CALL buyer to join the contract, because the value $\$(U-P_{0})$ should be larger than what the CALL buyer thinks they can make $\$(B_{T}-B_{0})$ from buying a BOND.

We can design the inverse scenario with a CALL-PUT option which focuses on the CALL buyer as follows.

CALL-PUT options

In a CALL-PUT option there are two parties, called the CALL buyer and the PUT buyer, who both buy into the contract by encumbering value. The CALL-PUT smart contract design is given by the following basic flow:

1. The CALL buyer encumbers $\$P_{0}$ cash in the contract.
2. The PUT buyer encumbers a BOND in the contract.
3. The CALL-PUT smart contract initates if both encumbrances have been executed by time $t=0$ , and matures at time $t=T$.
4. At maturity time $T$, the CALL-PUT smart contract swaps the BOND and the cash. I.e., the BOND token is given to the CALL buyer. The $\$P_{0}$ cash is given to the PUT buyer.

If the price of a BOND has increased $\$B_{T}>\$P_{0}$ at time $T$, then the CALL buyer profits. If the price has decreased $\$B_{T}<\$B_{0}$, the PUT buyer profits. In order to entice a CALL buyer to participate, the price of an actual BOND token $\$B_{0}$ should be larger than than $\$P_{0}$ or else the CALL buyer should just buy a BOND token at market. Thus $\$B_{0}-\$P_{0}$ is related to the premium from a traditional put option which the PUT buyer pays to entice the CALL buyer to participate.

Pure options

One of the advantages of traditional derivatives is that the underlying asset does not need to be purchased – your actual assets do not need to be encumbered in the contract if your promise to fulfill your bargain is reliable. The market relies on the reputation of its participants and the insurance that the market maker provides. This cannot be done for pseudonymous participants in an empty coding environment, without encumbering underlying assets. However, with REP tokens, we can build a history of good behavior that is valuable and will give the proper incentives for participants to honor contracts. This can be done with a more complex system of accounting for reputation. We can underwrite the reputation of the market.

See Also

• Fixed-period BOND
• Variable-period BOND
• Dev bounties
• Treasuries
• BOND Markets
  • Investor BONDs
  • Founder BONDs
  • Graceful Exit
  • Underwriting
  • Stable coins
  • generalized chit fund banking
• PoR block production consensus
• Governance BONDs