Cruize v2

Replicating Portfolio Intuition

Replicating portfolios are used to replicate the payoff function of a financial instrument such as a derivative to reconstruct the same return profile without actual exposure to the underlying instrument. For example, a replicating portfolio of a call option for a stock would be a long position in the stock with borrowed money. This portfolio is called a replicating portfolio because when the stock price rises above the purchase price (strike price), you can sell the stock and repay the debt to realise the difference (between the selling price and purchase price) as the profit. This payoff is similar to the payoff of exercising a call option in-the-money.
The hedging mechanism of Cruize is based on creating the replicating portfolio of a perpetual put option with strike price equal to the price floor of crTOKENs. This is because the option becomes in-the-money below the price floor and can be exercised to hedge the asset using the price floor.
Payoff of a long put position
The replicating portfolio for the perpetual long put is constructed using the below strategies:
  • A bond (IOU) on the asset to maintain exposure to the underlying (option not exercised if out-the-money)
  • A short position to extract the payoff in falling markets (option exercised if in-the-money)

Position Creation

The protocol uses perpetual swaps for short positions which are collateralized using debts on the underlying. The costs for the position include the interest rate on the debt and the funding fees of the short position. The underlying itself is lent out while being used as collateral to cover the position costs.
The protocol uses a combination of the following strategies to generate interest and hedge downside volatility

Access Debt

The staked asset is added to a lending protocol to access USDC debt on the staked balance. The USDC is used to collateralize the short position using perpetual swaps. The most important parameter for this step is the LTV of the debt. The debt size will only be a small fraction of the collateral size and the leverage on the short position depends on the fraction of the debt. The algorithm ensures that the LTV of the position never crosses a safe threshold that has an additional safety margin to prevent the liquidation of the collateral. Furthermore, the shorting strategy ensures that the debt position is eliminated before the LTV of the position reaches the safety threshold.
The size of the debt will be 25% of the collateral amount, making the starting LTV equal to 0.25

Short Position

The USDC acquired as debt is used to open the short position with 4x leverage at the price floor. With a debt value of 25% leveraged 4x, the entire asset amount can be covered using the position. The short position captures the payoff required to hedge the asset at the price floor. In a falling market, the debt position becomes more at risk, while the short position becomes profitable. One of the following 2 scenarios could play out while the position remains open:
  • The user redeems their crTOKENs before the short payoff becomes greater than the debt value. In such a case, the position is closed once the user withdraws their stake, the collateral from the short position is repaid as the debt, and the realized payoff is added to the market value of the asset (which is sold) to provide the price floor to the user
  • If the payoff of the short position becomes greater than the value of the debt, then the position is partially closed to realize the payoff used to repay the debt. Once the debt is repaid, the staked asset is reacquired and the collateral of the short position adds to the position equity needed to construct the payoff of the price floor.
If the user doesn't happen to redeem their crTOKENs below the floor, the position is closed at a price slightly lower than the price floor and the debt is repaid to reacquire direct access to the staked asset.
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Replicating Portfolio Intuition
Position Creation
Access Debt
Short Position