A volatility swap is a forward contract with a payoff based on the realized volatility of the underlying asset. They are settled in cash, depending on the difference between the realized volatility and the volatility strike or pre-determined fixed volatility level. Unlike typical swaps that involve an exchange of cash flows, volatility swaps allow participants to trade an asset’s volatility without directly trading the underlying asset.
Key Takeaways
- Forward Contract Payoff: A volatility swap is driven by the difference between realized volatility and a volatility strike.
- Notional Value Influence: The payoff is calculated as the notional value of the contract multiplied by the difference between realized volatility and the volatility strike.
- Not Traditional Swaps: Volatility swaps differ from typical swaps which involve an exchange of cash flows based on fixed and/or varying rates. Instead, they focus solely on a payoff based on volatility.
Understanding Volatility Swaps
Volatility swaps offer investors pure exposure to the volatility of an underlying asset without the influence of asset price movements. Essentially, investors speculate on how volatile an asset will be rather than its price.
Although termed ‘swaps’, these instruments are structured more like forward contracts with payoffs tied to the observed or realized variance of the asset. The underlying concept revolves around the difference between the realized and implied volatility.
At settlement, the payoff is determined as follows:
Payoff = Notional Amount * (Volatility - Volatility Strike)
The volatility strike is fixed at the swap’s inception, representing the market’s expectation of the asset’s volatility. This strike is analogous to implied volatility, yet it is distinct from traditional implied volatility in options. At inception, the notional amount is not exchanged, but the final payoff hinges on the difference between realized and expected volatility.
Utilizing Volatility Swaps
Volatility swaps serve as pure-play instruments on an asset’s volatility, unlike options that entail directional risk and dependence on multiple factors like time and expiration. Therefore, options require additional risk hedging strategies, but volatility swaps allow an investor to focus purely on volatility.
Volatility swaps serve three primary user classes:
- Directional Traders: Use these instruments to speculate on future volatility levels of an asset.
- Spread Traders: Bet on the discrepancy between realized volatility and implied volatility.
- Hedge Traders: Utilize swaps to cover short volatility positions.
In the equity markets, variance swaps are more prevalent than volatility swaps.
Brilliant Example of Volatility Swap Usage
Imagine an institutional trader opts for a volatility swap on the S&P 500 index. The contract has a notional value of $1 million and a duration of twelve months. At inception, the implied volatility is 12%, set as the contract strike.
In one year, if the realized volatility hits 16%, this results in a 4% difference. As a result, the seller of the volatility swap pays the buyer $40,000 ($1 million x 4%). If volatility were to drop to 10%, the buyer would instead pay the seller $20,000 ($1 million x 2%).
This simplified scenario demonstrates the operational dynamics of such instruments. In actuality, since volatility swaps are over-the-counter (OTC) instruments, they may vary in structure, potentially annualizing rates or calculating volatility differences in daily terms.
Related Terms: variance swap, forward contract, implied volatility, realized volatility, hedging.
