What drives the value of derivative asset
The price of a derivative asset and its sensitivity is driven by uncertainty about the outcome of the underlying and hence the uncertainty about the payoff of the derivative asset. The lower the uncertainty, the closer the price is tracking the actual payoff curve. The higher the uncertainty, the higher the divergence between the price and the underlying payoff curve. This basic concept is illustrated in below chart for a long position:
Price payoff relation of a long derivative asset
The grey arrows in the chart indicate the convergence of the price curve towards the payoff curve as the uncertainty about the outcome of the underlying decreases.
The following factors impact the perceived uncertainty and hence the price of a derivative asset:
- Current underlying value: The higher the current underlying value, the higher the price of a long position all else equal.
- Volatility: The higher the expected volatility of an underlying asset, the higher the chances of a large payoff for the holder of the derivative, the higher the price of the derivative all else equal.
- Time until expiration: The less time remaining until expiration, the higher the certainty about the final payoff of the derivative asset, hence the closer the price is tracking the actual payoff of the derivative asset.
As the maximum payout of position tokens issued by the DIVA Protocol is 1 unit of the collateral asset, the price of a position token always ranges between 0 and 1 and hence can be thought of as a probability. Further, the price is always quoted in the collateral asset. For example, if the collateral asset is WBTC, then the price would represent how much WBTC to pay in order to get a chance for a maximum payoff of 1 WBTC.
The goal of this section is to give some intuition behind each of these value drivers for non-technical readers.