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Growing population in the emerging economies of Southeast Asia, South America and rising prosperity in emerging countries, particularly China and India are driving demand of raw materials. Both countries are experiencing high income growth and a growing social middle class, which has led to changes in dietary behavior. For example, It is undisputed that the demand for cereals has increased with the changing food demands. Whether the higher per capita income has also led to greater demand for meat and dairy products is a matter of contrarian debate. Far more important in the context of competing uses, however, is the use of but the use of agricultural raw materials for energy production. As a result of the rise in crude oil and energy prices, more and more agricultural raw materials have been used for energy production in recent years. Seasonality, e.g. due to the specified sowing and harvesting periods, can also restrict supply. This is accompanied by seasonal price cycles. Wheat prices in Europe are higher in the first and third quarters than in the second and fourth quarters due to harvest cycles. Price volatility is also higher before harvest than after harvest.
Typically, price level increase and volatility correlate – that’s why lowering volatility will have increasing importance.
Hedging means financial protection. When parties talk about hedging, they want to protect themselves against a price or an exchange rate exceeding or falling below a limit they expect. The person who actively engages in hedging is the hedger. There are different financial instruments that have a hedging effect (“derivatives”).
Forwards
Options
Swaps
Stronghold focuses on options as a powerful financial product currently less used by small and medium sized enterprises given the complexity.
Options are pegged to an underlying product, for example, shares, bonds, commodities or currency pairs. By purchasing an option, you buy the right to either buy or sell a certain underlying asset at a certain time and at a predefined price. The exercise date is therefore in the future. The most important characteristic of options is that the purchase of the option always only gives the right to buy or sell, but not the obligation to execute the option. However, the seller of the option is obliged to sell the underlying asset at the agreed price at the given point in time. How do options work?
When you buy an option, you enter into a contract with an option seller, or writer, who guarantees that you can execute your option. The option seller receives an option premium in return. The option premium is always due, regardless of whether you execute the option or not. For example, if you buy an option on a wheat batch with a strike price of 100€, you will probably execute the option if the underlying wheat price rises above 100€ at the time of execution. If the underlying price falls, you will buy the stock on the capital market and let the option expire. However, you will have to pay the option premium to the option seller in both cases.
Call and Put Option In the case of options, a basic distinction is made between a call option and a put option. If I assume that a share will rise in the future, I buy a call option in order to have the opportunity to purchase this share at a lower price in the future. In the opposite case, i.e. when the share price is falling, I buy a put option in order to be able to sell the share at a higher price in the future.
Long and Short While call and put options are call and put options respectively, "long" and "short" refer to the buying and selling position respectively. "Long" is the name given to the buyer's position, which bets on rising prices, while "short" is the name given to the seller's position, which profits from falling prices. Consider here that the salesman receives in each case the option premium, the buyer pays it however. This is associated with a different risk profile, even if, for example, both long call and short put options bet on rising prices. If you compare the two options directly, they each have a specific price window in which they would make a higher profit.
Protective Call Option ("Collar" Option) A Collar Option is similar to a Call Option with the difference that the payout is called at a second strike price. This cap protects the Short position (Call Option seller) against unlimited loss. The first strike price is called Put Strike ("Kp") and the second strike price is called Call Strike ("Kc"). This is because the Collar Option can be synthetically created by 1) beeing in a Long position of the Underlying and 2) beeing in a Long postion of a Put Option at price Kp and 3) beeing in a Short position of a Call Option at priceKc. The price corridor, the collar, is where the hedger is hedged. If the underlying price exceed Kp the hedger is again exposed to the market movements of the underlying price. A cap somewhere is important to limit the loss of the liquidity pool. This allows calculating a maximum funding needed in the pool to be bulletproof against payment defaults.
Market makers are members of marketplaces who quote bid and ask prices for the demanded of supplied securities and trade them themselves at their own risk and for their own account. In many cases, this is the only way to ensure sufficient liquidity. stronghold is a market maker, that is able to always supply a demanded option or always buy an option against a certain fee.
stronghold is provider and market makers of cash-settled protective options. Hedgers can request option quotes anytime and buy hedge products.
stronghold has a liquidity pool, that ensures option payouts at exercise date. The liquidity pool is at all time over-collaterized protecting against payment defaults. The over-collaterization is calculated based on the worst case payout scenario of each option reaching or exceeing the upper end of the payout schedule.
In the crypto world, a liquidity pool is a place where token holders can lend their tokens so that a supply of tokens is available on decentralized exchanges at all times. In return, token holders receive a proportional percentage of the fees from all transactions made. stronghold’s liquidity pool ensures to always provide bid and ask prices to buy and sell options.
Each ETH investor in the liquidity pool with receive $SRONG tokens that represent their stake in the liquidity pool.
Prices from underlying commodities are delivered by decentralized oracles, such as Flux Protocol and chainlink. These platform ensure price feeds that are validated by a multiple of independent nodes. In addition the price source API names are publicly visible to ensure transparency back to the ultimate data source. These sources could be well known institutions or foundations.
Price deliverer and validators are compensated with a commission for each data point they deliver or validate. This data feed network is outside the scope of stronghold, even though stronghold developer team closely work together with the data provider networks. In order to become a deliverer or validator, you can reach out to stronghold here. Stronghold does not need to know your identity but the developer team can help setting up the validator node together with Flux or chainlink.
Anyone can set up new underlying price feeds. The standard process would be as follow:
Any underlying, like a stock or a commodity, has a time series of prices that behave like a random walk with drift, and a specific statistical probability distribution. Reality data, such as “the current temperature in London” behaves similar, though, often with specific behaviors, such as strong cyclicality, stronger bias to fat tails or stronger auto-correlation.
Taking reality data as underlying for an option would not allow to use classic valuation methodologies such as Black & Scholes. For example the temperature time series is too cyclical to be valued with Black & Scholes, that takes as input a probability distribution, mostly the Normal Distribution.
Still, taking all the attributes and empirical data of reality data time series into account, discrete time series models such as Cox, Ross Rosenstein, can be modified to create decent predictions. This allows stronghold to provide Options on any kind of reality data time series as if it was a stock on the stock exchange. Examples could be to hedge against rainfall as a restaurant, against heavy sun as a farmer, against delivery delays due to traffic jams, and many more.
The data feed creation and networks that source and validate these data, so-called Oracles, are one of the most critical part of crypto, given they link the real world with the chain. Problems of Oracles There is a lot of literature online explaining the Oracle problems and how to solve them. Therefore we don’t want to further dive into this topic but rather refer to some readings:
stronghold uses a dataset of historic data with constant enrichment of new data points and state-of-the-art preduction models to provide fair valuation the options. Spme of the methodologies are listed below:
stronghold is developing managed wallets on proprietary, centralized server to facilitate interacting with the stronghold contracts on the Etherium mainnet. Thus, stronghold will provide an API that allows to link a credit card to a managed wallet and offers a list of endpoints such as:
/authenticate
/hedge
/fundWallet
/getQuote
/exercise