Examples
Holding Long/Short tokens doesn't mean that the interest rate of the underlying lending protocol can be converted from floating to fixed, but achieving fixed interests by taking a position that gives you an opposite PnL from interest rate fluctuation.
Take fixed borrowing interest rate for example.
Given that a term in iGain will be expired in one year and the leverage level is 10x.
Jack borrows $10,000 from Aave and spends $400 buying 1,000 Long tokens with an average price of $0.4 in the beginning, then he can realize a 4% fixed interest rate regardless of actual interest rate.
Here are some possible scenarios and we provide the calculation approaches for the final result.
Case 1:
After one year, the interest rate on Aave becomes 8%.
At that time, Jack's borrowing interest on Aave is $800 while the settled price of Long token is $0.8. Jack can redeem $800 with a net profit of $400.
Net PnL = (Interest) -$800 + (Long) $400 = -$400
Sum up the interest paid for Aave and the profits made from Long tokens, the cost for borrowing equals $400, which is a 4% interest rate.
Case 2:
After one year, the interest rate on Aave becomes 3%.
At that time, Jack's borrowing interest on Aave is $300 while the settled price of Long token is $0.3. Jack can redeem $300 with a net loss of $100.
Net PnL = (Interest) -$300 + (Long) -$100 = -$400
Sum up the interest paid for Aave and the hedge made from Long tokens, the cost for borrowing will be $400, which is still a 4% interest rate.
As stated above, we can conclude that whether the interest rate one year later is higher than 4% or not, the final net income or loss will be -4% if investors get enough Long tokens in advance. The ups and downs in two positions can be offset.
More Scenarios
As investors buy enough Long tokens, the float of future interest rates can be hedged by the payoff of Long tokens. To further explain it, there is a table to list down all possibilities.
If investors spend $40 buying 100 Long tokens with an average price of $0.4, then the net income or loss of different interest rates on Aave one year later is as follows.
3%
-$30
$0.3
-$10
-$40
4%
4%
-$40
$0.4
0
-$40
4%
8%
-$80
$0.8
$40
-$40
4%
10%
-$100
$1.0
$60
-$40
4%
14%
-$140
$1.0
$60
-$80
8%
The table shows that no matter how the interest rate fluctuates, investors can hedge future interest rates by purchasing Long tokens once the borrowing interest rate on Aave is lower than 10%.
If the interest rate is higher than 10%, then only part of the interest rate strike can be hedged. For example, although investors fail to fix interest rate to 4%, they can lower the interest rate from 14% to 8% while buying Long tokens with an average price of $0.4 in advance.
* The hedgeable range of interest rate is determined by the leverage level. The higher the leverage rate is, the smaller the range is. The upper limit interest rate is 100% / levereage level.
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