Impermanent loss is a potential risk that investors face when participating in yield farming, which involves depositing assets in liquidity pools to earn rewards. Impermanent loss occurs when the price of the assets in the pool diverges from the initial exchange rate at which the investor deposited them. When the price of one asset in the pool goes up relative to the other, the pool may be imbalanced, and investors may suffer losses. This happens because the smart contract will automatically sell the asset that has appreciated and buy the asset that has decreased in value, causing the investor's holdings to be worth less than if they had simply held the assets outside of the liquidity pool. The loss is called "impermanent" because it only occurs if the investor withdraws the liquidity before the price returns to the initial exchange rate.

Impermanent loss occurs when the value of assets deposited in a liquidity pool (LP) decreases compared to simply holding them outside the pool. This happens due to price volatility between the paired tokens; when their relative prices change, arbitrage traders rebalance the pool, reducing the LP's value.

The loss is "impermanent" because if the token prices return to their original ratio, the loss disappears. However, if the prices diverge permanently, the loss becomes real. Yield farming rewards (e.g., trading fees or token incentives) can offset this loss, but high volatility increases risk.

Understanding impermanent loss helps liquidity providers assess whether potential rewards justify the risks before participating in DeFi protocols.