Optimal Hedge Ratio for Delta-Neutral Liquidity Provision under Liquidation Constraints
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arXiv
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| Format: | Preprint |
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2026
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| _version_ | 1866910061177077760 |
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| author | Hane, Atsushi |
| author_facet | Hane, Atsushi |
| contents | We study the problem of optimally hedging the price exposure of liquidity positions in constant-product automated market makers (AMMs) when the hedge is funded by collateralized borrowing. A liquidity provider (LP) who borrows tokens to construct a delta-neutral position faces a trade-off: higher hedge ratios reduce price exposure but increase liquidation risk through tighter collateral utilization. We model token prices as correlated geometric Brownian motions and derive the hedge ratio h that maximizes risk-adjusted return subject to a liquidation-probability constraint expressed via a first-passage-time bound. The unconstrained optimum h* admits a closed-form expression, but at h* the liquidation probability is prohibitively high. The practical optimum h** = min(h*, h_bar(alpha)) is determined by the binding liquidation constraint h_bar(alpha), which we evaluate analytically via the first-passage-time formula and confirm with Monte Carlo simulation. Simulations calibrated to on-chain data validate the analytical results, demonstrate robustness across realistic parameter ranges, and show that the optimal hedge ratio lies between 50% and 70% for typical DeFi lending conditions. Practical guidelines for rebalancing frequency and position sizing are also provided. |
| format | Preprint |
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arxiv_https___arxiv_org_abs_2603_19716 |
| institution | arXiv |
| publishDate | 2026 |
| record_format | arxiv |
| spellingShingle | Optimal Hedge Ratio for Delta-Neutral Liquidity Provision under Liquidation Constraints Hane, Atsushi Portfolio Management We study the problem of optimally hedging the price exposure of liquidity positions in constant-product automated market makers (AMMs) when the hedge is funded by collateralized borrowing. A liquidity provider (LP) who borrows tokens to construct a delta-neutral position faces a trade-off: higher hedge ratios reduce price exposure but increase liquidation risk through tighter collateral utilization. We model token prices as correlated geometric Brownian motions and derive the hedge ratio h that maximizes risk-adjusted return subject to a liquidation-probability constraint expressed via a first-passage-time bound. The unconstrained optimum h* admits a closed-form expression, but at h* the liquidation probability is prohibitively high. The practical optimum h** = min(h*, h_bar(alpha)) is determined by the binding liquidation constraint h_bar(alpha), which we evaluate analytically via the first-passage-time formula and confirm with Monte Carlo simulation. Simulations calibrated to on-chain data validate the analytical results, demonstrate robustness across realistic parameter ranges, and show that the optimal hedge ratio lies between 50% and 70% for typical DeFi lending conditions. Practical guidelines for rebalancing frequency and position sizing are also provided. |
| title | Optimal Hedge Ratio for Delta-Neutral Liquidity Provision under Liquidation Constraints |
| topic | Portfolio Management |
| url | https://arxiv.org/abs/2603.19716 |