Pricing model

Pricing

A more straightforward way to break down the economic theory behind BNPL options is to consider the insurance markets. The economic principle behind BNPL options is essentially allowing users to buy market-priced insurance on their options should there be a need to cut losses and default.

• L = number of losing positions

• F = % of defaulted losing positions

• Z = total number of options purchased in protocol

• P = normal price premium of an uninsured option

• p = additional premium for BNPL options

• d = % downpayment on BNPL option premium

• s = remainder of servicing fee for BNPL options

• W = number of winning positions

• A = % of winning positions

The following formulae give the theoretical pricing formula for BNPL options:

Premium charged for BNPL option = P(1+p)

Pricing additional premium: pZ = (1+p)(P)(AW) + (1+p)(P)(d) - (FL)(s)

p = [(1+p)(P)(AW) + (1+p)(P)(d) - (FL)(s)]/Z

The value of p will have to be constantly rebalanced and subject to regression testing to determine the fair market price.

Economics

If the pricing model seems overwhelming, don't worry. In essence, it serves two important economic purposes in its value proposition: enhancing capital efficiency and redistributing returns.

This is done by mitigating downside risk through defaults on unprofitable positions, acknowledging that no individual investor consistently predicts market directions correctly. This approach, although reduces potential upside returns by paying a premium on the option, ultimately reduces risk, leading to a more consistent level of returns over time.