Variance swap Totally Explained

Everything about Variance Swap totally explained

A variance swap is an over-the-counter financial derivative that allows one to speculate on or hedge risks associated with the magnitude of movement, for example volatility, of some underlying product, like an exchange rate, interest rate, or stock index. One leg of the swap will pay an amount based upon the realised variance of the price changes of the underlying product. Conventionally, these price changes will be daily log returns, based upon the most commonly used closing price. The other leg of the swap will pay a fixed amount, which is the strike, quoted at the deal's inception. Thus the net payoff to the counterparties will be the difference between these two and will be settled in cash at the expiration of the deal, though some cash payments will likely be made along the way by one or the other counterparty to maintain agreed upon margin.

Structure and features

The features of a variance swap include:

the variance strike
the realised variance
the vega notional: Like other swaps, the payoff is determined based on a notional amount that's never exchanged. However, in the case of a variance swap, the notional amount is specified in terms of vega, to convert the payoff into dollar terms.

The payoff of a variance swap is given as follows:
ť

N_

is the corresponding vega notional for a volatility swap. This makes the payoff of a variance swap comparable to that of a volatility swap, another less popular instrument used to trade volatility.

Pricing and valuation

The variance swap may be hedged and hence priced using a portfolio of European call and put options with weights inversely proportional to the square of strike.
Any volatility smile model which prices vanilla options can therefore be used to price the variance swap. For example, using the Heston model, a closed-form solution can be derived for the fair variance swap rate. Care must be taken with the behaviour of the smile model in the wings as this can have a disproportionate effect on the price.

Uses

Many find variance swaps interesting or useful for their purity. An alternative way of speculating on volatility is with option, but if one only has interest in volatility risk, this strategy will require constant delta hedging, so that direction risk of the underlying security is approximately removed. What is more, a replicating portfolio of a variance swap would require an entire strip of options, which would be very costly to execute. Finally, one might often find the need to be regularly rolling this entire strip of options so that it remains centered around the current price of the underlying security.
The advantage of variance swaps is that they provide pure exposure to the volatility of the underlying price, as opposed to call and put options which may carry directional risk (delta). The profit and loss from a variance swap depends directly on the difference between realized and implied volatility.
Another aspect that some speculators may find interesting is that the quoted strike is determined by the implied volatility smile in the options market, whereas the ultimate payout will be based upon actual realized variance. These two are not usually the same and thus creates an opportunity for volatility arbitrage. Fot the same reason, these swaps can be used to hedge Options on Realized Variance.

Related instruments

Further Information

Get more info on 'Variance Swap'.

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