Understanding how Bumper assesses risk and calculates premiums is crucial for users seeking to optimise their position and maximise revenue. In this guide we delve into the inner workings of the Bumper premium mechanism, shedding light on its calculation process, the risk rating system, and strategies for maximising efficiency.
The premium is the cost incurred by users to obtain price protection for their assets. Unlike traditional options markets which rely on fixed premiums determined by individual agreements between buyer and seller, Bumper employs a dynamic pricing mechanism wherein the premium accumulates over time. It’s influenced by three factors:
1. Price Risk Factor: Bumper continuously monitors asset prices. The protocol uses an algorithm to analyse recent price behaviour and generates a figure as a proxy for the asset’s price volatility. The higher the volatility, the higher the Price Risk Factor, and the higher the premium.
2. Liquidity Risk Factor: In addition to price risk, the Bumper protocol explicitly considers liquidity risk in pricing premiums. Liquidity risk refers to the risk that a given Bumper protection market is unable to satisfy a claim by a Taker or Maker on the market’s asset or capital pools. While the probability that this actually occurs is extremely small given (it would take a combination of price volatility well in excess of historical events combined with a final outsized price drop and an extreme absence of pool liquidity), during periods of high demand or market stress, the liquidity risk will typically rise. By analysing the market’s liquidity ratios, Bumper ensures that premiums are adjusted to reflect changes in market conditions and protocol liquidity.
3. Risk Rating of Positions: Every Taker position within the Bumper protocol is assigned a risk rating based on two factors: term length and floor price. This risk rating influences the level of liability risk associated with the position and, consequently, the premium charged. Floor price is straightforward to understand - the higher the chosen floor price, the higher the risk rating and the higher the premium accumulation. On the other hand, longer terms are offered a discount on their risk rating. So the longer the protection term, the lower the premium rate.
The Bumper protocol is engineered to maximise the efficiency of pricing asset price risk to achieve provably fair premiums for Takers, and consistently competitive yields for Makers. We’ve done this by following a few key design principles:
Taking the ‘bet’ out of the ‘option’
Spreading the risk
For Takers, the dynamic premium is accumulated globally at a pool level for all protection positions. Individual premiums can then be determined at any time based on the Taker’s individual risk factor and the timeframe they have been protected. This method is a computational method that allows any number of Takers to be in the market without having the gas cost for transactions explode.
For Makers it’s a little different, while their yield is dynamic, it doesn’t accumulate the way premiums do for Takers. Instead, Makers share a global yield pool that, at any point in time, can be positive or negative. The value of that yield pool (known as the “Market Yield”) can be split proportionally among all Makers (again according to their risk). Superior to finding oneself selling a Put Option that needs to be paid out at maturity, if a Maker, at the end of their term is faced with a negative yield, they can either wait until the prevailing risk has passed to withdraw (during which time higher premiums accumulate) or, they can simply renew their position and earn for a longer period. In this way, no single participant bears the full brunt of price volatility, helping to stabilise the protocol’s economics and encourage participation.
Different terms and floor levels (for Takers), or tiers (for Makers), map to higher or lower risk ratings, which allow for individualised positions within the protocol. As such, in creating a new position in Bumper, the choice of term and floor/tier is a reflection of the individual user’s risk appetite.
With a high floor, say 99%, the likelihood that the position will be able to make a claim is higher than it would be with a lower floor. Term lengths, on the other hand, offer lower risk ratings for longer terms rather than higher. This should be counterintuitive to options traders (it’s harder to predict what will happen over longer time horizons than shorter ones), but the reason longer terms offer a lower risk rate instead of a higher one is statistical; a dynamic premium has a longer opportunity to converge to the long-term fair price and, therefore, has less error in the result.
The matrix below illustrates the relationship between the two decisions a taker makes.
Let’s recap how the Premium is computed.
Under the hood, the contracts are following this process:
To maximise efficiency within the Bumper protocol and ensure that premiums do not erode profits, users must make informed decisions when entering positions. Key considerations include:
1. Risk Assessment: Conduct a thorough risk assessment to determine the level of protection needed. Consider factors such as asset volatility, market trends, and liquidity conditions.
2. Asset Behavior Analysis: Analyse historical asset behaviour and market trends to anticipate potential price movements and adjust position risk strategies accordingly.
3. Risk Market Observation: Look at both the cost and convenience of alternatives (such as Deribit).
Please also remember that at the end of the fixed term your position will remain protected, but the premium charges will revert to a higher rate compared with your in-term rate. So make sure you’re closing, claiming or renewing your position as soon as possible after term expiry to optimise your premium.
