Pricing methodology
How the pricing engine turns market data into a signed fair rate, and how the currency-pool contract turns that rate into a premium and later a payout. The models are standard and published; this section says where each one comes from and where BlockFinaX adapts it for frontier currencies.
| Page | What it covers |
|---|---|
| Walkthrough | One contract priced from start to finish, every step with its formula and numbers |
| Formula handbook | Each formula explained from first principles: what it is, why it is used, how it works, its symbols, its limits and a worked example |
The process in four parts
- What the protection pays. The buyer chooses notional, duration, strike and limit. The contract's payout rule turns the settlement rate into USDC.
- How likely each outcome is. From the pair's history, the engine estimates the distribution of the rate at expiry: drift, volatility, and the chance of sudden jumps.
- The fair price. The fair price is the expected payout under that distribution, in today's money. The currency option formula computes it exactly.
- What the buyer pays and receives. The contract applies the pool's markup and the protocol fees to the signed fair rate, and at expiry pays from the oracles' agreed rate.
Parts 1 to 3 run off-chain in the pricing engine; the contract receives the result as a signed quote (see Signed quotes). Part 4 runs on-chain in buy_protection, settle_position and claim_payout.
The standard market method
Banks price currency options with four ingredients, all read from live markets:
- The formula: Garman-Kohlhagen [1].
- Today's rate: a recognised fixing or dealer quotes.
- The forward rate: the forward market, or the two currencies' interest rate curves.
- Volatility: implied by the options market, including how it varies across strikes (the smile), fitted with methods such as Vanna-Volga or SABR.
Adaptations for frontier currencies
In frontier markets ingredients 3 and 4 are thin or missing. The engine keeps the standard formula and substitutes each missing input.
| Standard input | Substitute | Basis |
|---|---|---|
| Implied volatility | Exponentially weighted historical volatility, raised by a margin for the market type and held above a minimum, then blended toward the long-run level over the contract's life | RiskMetrics [4], GARCH(1,1) [5] |
| Forward rate | The pair's own five-year trend, capped at ±50% a year | Covered interest parity [1] [6], with the drift taken from history |
| Smooth moves | Merton jump diffusion with jump settings per market type | Merton [3] |
| Clean data | Freshness checks on the price history; quotes refused when maximum payout is over 100 or under 1.5 times the premium | BlockFinaX rule |
Where it lives in the code
| Part | File |
|---|---|
| Option formulas and the normal distribution | server/pricing/kernel.ts |
| Volatility | server/pricing/data/vol.ts, vol-math.ts |
| Long-run blend | server/pricing/data/garch.ts |
| Drift | server/pricing/data/drift.ts |
| Jump settings | server/pricing/data/jump-params.ts |
| USD interest rate | server/pricing/data/usdRate.ts |
| Quote assembly and checks | server/pricing/quote.ts |
| Premium, fees, payout | contracts/currency-pool (buy_protection, settle_position, claim_payout) |
References
- Garman, M. B. and Kohlhagen, S. W. (1983). Foreign currency option values. Journal of International Money and Finance, 2(3), 231 to 237.
- Black, F. and Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81(3), 637 to 654.
- Merton, R. C. (1976). Option pricing when underlying stock returns are discontinuous. Journal of Financial Economics, 3(1 and 2), 125 to 144.
- J.P. Morgan and Reuters (1996). RiskMetrics Technical Document, fourth edition. Source of the λ = 0.94 decay for daily volatility.
- Bollerslev, T. (1986). Generalized autoregressive conditional heteroskedasticity. Journal of Econometrics, 31(3), 307 to 327.
- Hull, J. C. Options, Futures, and Other Derivatives. Pearson. Chapters on currency options, option spreads, and estimating and forecasting volatility.
- Abramowitz, M. and Stegun, I. A. (1964). Handbook of Mathematical Functions. Formula 7.1.26, approximation of the normal distribution.
- EMTA. Template terms for non-deliverable forward and option transactions, which set the settlement rate source for each emerging-market currency.