This article aims to provide an overview of measuring price risk in decentralized finance (DeFi). It references delta and beta strategies. If you are unfamiliar with risks, you can read our articles on DeFi risk, managing DeFi risks, and how to do your own research. You can also consider reading our introductory articles on DeFi, blockchain, and cryptocurrency before reading this article.
DeFi has seen a noticeable increase in popularity in 2021. Many have looked to DeFi, a rapidly growing component of the crypto and financial ecosystems, to stake, participate, and earn greater yield. However, high rewards also come with high risk, and investors should learn to measure risk in this new and rapidly changing environment. A good strategy to start with would be determining price risk.
Price risk is the risk that the value of a security or investment will decrease. It can allude to several factors, including volatility, poor business management, and price changes.
Why Is There Risk?
In investing, risk is the uncertainty users take to make returns on their investments in both traditional finance (TradFi) and DeFi. As the adage goes, “there is no free lunch in this world.” Unless users utilize strategies free from price risk, such as arbitraging, risk is unavoidable when generating profit. Buying Bitcoin (BTC), for example, is simply a wager that BTC will grow in value. However, because of uncertainty, there is always the risk that BTC’s price will fall due to unforeseen market events. That is the essence of risk!
Who Bears the Risk? Can Risk Be Avoided?
Often, the investor carries the risk of the investment, but in some cases, institutions and funds invest on behalf of their clients. Trading and investing can be described as a zero-sum game since both parties on each side of the deal take the same risks. Ultimately, risk can never be destroyed, and anyone who participates in the market will bear the risk of potentially losing their monies.
How to Measure Price Risk
Measuring and assessing risk is the second step in the risk management framework after identifying risks. It is important for users to know what type of risks they are exposed to, as well as to measure the likelihood and impact of the risks so mitigation strategies such as hedging can be put in place.
There are many ways to measure price risk using quantitative methods. For this piece, we will be covering:
Delta is one of the four common Greeks used in options to assess risk exposure. The other three Greeks, Gamma, Vega, and Theta, will not be expounded on in this article.
Delta refers to the theoretical estimate of how a user’s position would change given a $1 increase in the underlying asset. For options, delta ranges from -1 to 1. However, the delta is usually binary for spot markets, either 1 or -1.
Delta is used to assess total directional risk. Directional risk simply refers to the risk of loss arising from exposure to the direction of the asset. Bullish strategies, such as buying crypto, have positive deltas, while bearish strategies, such as short-selling crypto, have negative deltas.
Here is a closer look at delta with an example:
- Alice’s portfolio holds 1 Ether (ETH) which she bought at US$2,000
- Alice’s portfolio has a delta of 1
- If ETH falls by $1, Alice will incur an unrealized loss of $1
The above example may seem straightforward. However, delta is extremely useful for assessing portfolios with multiple positions across different cryptocurrencies or strategies. The “net delta”, which is the aggregate delta figure, can provide a holistic view of an investor’s portfolio directional risk. This can also help with delta hedging.
Lastly, there are delta-neutral strategies that are agnostic to direction since the underlying position has no delta (meaning no directional risk).
Beta measures the systematic risk an individual cryptocurrency or basket (i.e., meme coins, Top 10 altcoins, NFT tokens) has relative to the entire crypto market. The market is always the benchmark that an investment’s beta is compared against, and the market always has a beta of 1. An appropriate benchmark is the total crypto market capitalization or the S&P 500 Index if you are measuring your DeFi investments against traditional finance (TradFi) markets. Here is what beta values represent:
Beta = 1: Token has the same volatility profile as the market
Beta > 1: Token is more volatile than the market
Beta <1: Token is less volatile than the market
Beta is most useful when comparing an investment against the broad market, depending on what the benchmark is. Beta is calculated by dividing the covariance of the excess returns of an investment and the market by the variance of the excess market returns. Click here to learn how to calculate beta.
Beta = Covariance ÷ Variance
Beta can also measure the scale of volatility a token has compared to the market. For example, if a token’s beta is 1.2, the asset is considered 20% more volatile than the market. Beta is helpful when comparing across tokens — at a glance, beta easily identifies that an investment with a beta of 1.2 is more volatile than an investment with a beta of 1.1. The table below shows more examples:
|Beta||If the Market Increases by $1|
|Token A||1.5||Token A will increase by $1.50 ($1 × Beta of 1.5)|
|Token B||2||Token B will increase by $2 ($1 × Beta of 2)|
|Token C||0.5||Token C will increase by $0.50 ($1 × Beta of 0.5)|
|Token D||-1||Token D will decrease by -$1 ($1 × Beta of -1)|
Beta is an extremely crucial figure when it comes to diversification strategies. Since beta is dynamic and not static, market conditions change over time, and especially so in crypto. The assumption is that we are calculating beta using historical data. Hence, beta might change in the future.
Volatility is a popular metric used in the investment community to assess risk. Volatility refers to the amount of uncertainty or risk related to the size of changes in a token’s value. Note that volatility is denoted by the greek symbol, sigma (σ).
A higher volatility means that a token’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short period in either direction. On the other hand, lower volatility means that a token value does not fluctuate dramatically and tends to be steadier.
Investors who are more risk-averse or have a low-risk appetite would tend towards low-volatility investments as the drawdowns are smaller relative to higher volatility investments. On the other hand, risk-seeking investors prefer high-volatility investments as they may be compensated with higher returns. Which type of return stream are you more comfortable with? The red line or the black line?
Volatility is measured as either the standard deviation or variance between returns from that same security or market index. Stablecoins, in theory, should have a volatility of 0% since they are meant to be pegged to the reference currency. On the other hand, altcoins such as Solana have an annualized volatility of over a 120%. Volatility can be calculated by taking the square root of the product of daily variance of a token’s returns and 365 days. Otherwise, most charting platforms provide simple volatility indicators for users.
Volatility = √(Daily Variance × 365 days)
Here are some commonly known crypto and their average annual historical volatility.
|Token||Historical Volatility (180 days)|
How to Minimize Risk
It is important to minimize and mitigate risks. The most commonly used strategies:
- Hedging with Derivatives
- Stop Losses
Diversification is based on the idea that all your eggs cannot be put in one basket. Investors are encouraged to diversify their portfolio holdings to minimize concentrated risk. Hedging, on the other hand, utilizes derivatives to create inverse positions that will offset any losses incurred on the underlying asset in which a portfolio has positions in.
Interested to find out more? Stay tuned for our upcoming articles, where we will be deep dive into these two strategies.
At Treehouse, we want to empower people to confidently navigate DeFi, and this includes helping users with understanding and assessing risk properly. In case you missed it, check out our recommended list of risk-related pieces!
- How to Make Sense of Metrics in DeFi
- The Truth About Audits in DeFi
- DeFi Risks: What You Need to Know
- How to Manage Your Defi Risks With This Framework
- Introducing Price Risk and Basic Trading Strategies
- Flash Loans and Flash Loan Attacks? What Are They and How to Prevent Them?
- A Look Back at Past Crypto Winters: Then Till Now
New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to get a comprehensive analysis of your DeFi assets. Lastly, subscribe to newsletter updates in the box below!