1.6 Impermanent loss

Impermanent loss (IL)

Example 1: Equal Value Assets Let's consider a scenario where you provide liquidity to a pool with two assets, Asset A and Asset B, each initially valued at $1. You contribute an equal value of $100 to each asset.

After some time, due to market fluctuations, the value of Asset A increases by 50% to $1.50, while the value of Asset B decreases by 25% to $0.75.

Now, if you were to withdraw your liquidity from the pool, you would receive 66.67 units of Asset A (100 / 1.50) and 133.33 units of Asset B (100 / 0.75). However, if you had simply held the assets individually without providing liquidity, you would have had 100 units of Asset A and 100 units of Asset B.

The difference between the amount you would receive by providing liquidity and the amount you would have if you had held the assets individually is the impermanent loss. In this case, the impermanent loss would be 33.33 units of Asset A (100 - 66.67) and 33.33 units of Asset B (133.33 - 100).

Example 2: Unequal Value Assets Let's consider another scenario where you provide liquidity to a pool with Asset A initially valued at $1 and Asset B initially valued at $2. You contribute $100 worth of each asset.

After some time, due to market fluctuations, the value of Asset A increases by 25% to $1.25, while the value of Asset B decreases by 20% to $1.60.

If you were to withdraw your liquidity from the pool, you would receive 80 units of Asset A (100 / 1.25) and 62.5 units of Asset B (100 / 1.60). However, if you had held the assets individually without providing liquidity, you would have had $125 worth of Asset A and $100 worth of Asset B.

The difference between the amount you would receive by providing liquidity and the amount you would have if you had held the assets individually represents the impermanent loss. In this case, the impermanent loss would be $45 worth of Asset A ($125 - 80) and $37.5 worth of Asset B ($100 - 62.5).

These examples illustrate the concept of impermanent loss, which occurs when the relative prices of assets in a liquidity pool change compared to holding those assets individually. Impermanent loss can vary based on the degree of price divergence and the initial asset allocations in the liquidity pool. It's important to carefully consider and understand impermanent loss risks before providing liquidity in DeFi pools.