A variance swap is a financial derivative used to hedge or speculate on the magnitude of price movement of an underlying asset. These assets can include exchange rates, interest rates, or the price of an index. At its core, the variance captures the difference between an expected result and the actual outcome.
A variance swap functions similarly to a volatility swap, the latter utilizing realized volatility instead of variance.
Key Takeaways
- A variance swap is a derivative contract involving two parties exchanging payments based on the underlying asset’s price changes, or volatility.
- Directional traders use these swaps to speculate on future asset volatility. Spread traders bet on the difference between realized volatility and implied volatility while hedge traders use swaps to cover short volatility positions.
- If realized volatility exceeds the strike, the payoffs at maturity are positive.
How a Variance Swap Works
Similar to a plain vanilla swap, one of the involved parties in a variance swap transaction will pay an amount based on the actual variance of price changes of the underlying asset. The other party will pay a fixed amount, known as the strike, specified at the start of the contract. The strike is typically set to make the net present value (NPV) of the payoff zero.
At the contract’s end, the net payoff to the counterparties amounts to a theoretical figure multiplied by the difference between realized variance and a fixed amount of volatility, settled in cash. Due to specified margin requirements in the contract, some payments may occur during the contract’s life if its value moves beyond set limits.
Mathematically, a variance swap involves the arithmetic average of the squared differences from the mean value. The square root of the variance is the standard deviation. Therefore, the payout structure of a variance swap, based on variance rather than standard deviation, will be larger compared to a volatility swap.
A variance swap offers a focused play on an asset’s volatility. While options also allow speculation on an asset’s volatility, they entail directional risk and their pricing is influenced by multiple factors, such as time, expiration, and implied volatility. Consequently, the equivalent options strategy necessitates additional risk hedging. Variance swaps are usually less expensive to implement since the equivalent of an option requires a strip of options.
Types of Users
There are three primary types of users for variance swaps:
- Directional Traders: Use these swaps to speculate on the future volatility levels of an asset.
- Spread Traders: Bet on the difference between realized volatility and implied volatility.
- Hedger Traders: Utilize swaps to cover short volatility positions.
Additional Variance Swap Characteristics
Variance swaps are particularly well-suited for speculation and hedging on volatility. Unlike options, variance swaps do not require additional hedging, such as delta-hedging. Moreover, the payoff at maturity to the long holder of the variance swap is always positive when realized volatility exceeds the strike.
Buyers and sellers of variance swaps should consider that significant jumps in the price of the underlying asset can skew the variance and produce unexpected results.
Related Terms: Derivative, Hedge, Volatility Swap, Plain Vanilla Swap, Net Present Value, Counterparty, Variance, Standard Deviation.
