How Do Variance Swaps Work?

A financial instrument called a variance swap is used to hedge or speculate on the amount of an underlying asset’s price change. These assets might be interest rates, currency rates, or index prices. The variance is the discrepancy between the predicted and actual outcomes.

A volatility swap, which uses realized volatility rather than variance, is similar to a variance swap.

The Workings of a Variance Swap

One of the two parties to a var swap transaction will pay a sum determined by the natural variance of price movements of the underlying asset, just as in a simple vanilla swap. As stated at the beginning of the contract, the opposite party will pay a certain sum, known as the strike. The strike is usually fixed from the start to make the payoff’s net present value (NPV) zero.

The counterparties’ net compensation at the end of the contract will be equal to the variance times a predetermined level of volatility, and the payout will be in cash. Should the contract’s value rise over certain thresholds, certain payments may be made throughout its duration due to any margin requirements mentioned in the agreement.

In mathematical terms, the variance swap equals the arithmetic mean of the squared deviations from the mean value. The standard deviation is the variance squared. Because the foundation of both products is variance rather than the standard deviation, the payoff of a variance swap will be greater than that of a volatility swap.

A variance swap is a pure gamble on the volatility of an underlying asset. An investor may also bet on the volatility of an asset by using options. However, there is directional risk associated with options, and their pricing is subject to many variables, such as implied volatility, time, and expiry. Thus, more risk hedging is needed to complete the corresponding option strategy. Because a strip of options represents the equivalent of a choice, variance swaps are also less expensive.

Three primary user types use variance swaps.

• Directional traders use these swaps to predict an asset’s volatility.
• All spread traders do is wager on the implied and realized volatility discrepancy.
• Hedge fund traders use swaps to cover short-volatility holdings.

Additional Features of Variance Swaps

Variance swaps work effectively for volatility hedging or speculating. Variance swaps don’t need further hedging, unlike options. Options may need to be hedged using delta. Additionally, if realized volatility exceeds the strike, the variance swap’s longholder will always get a positive payout at maturity.

Buyers and sellers of volatility swaps must know that sizeable underlying asset price fluctuations might distort the variance and have unanticipated consequences.

Conclusion

• A variance swap is a derivative contract where two parties trade payments according to the underlying asset’s price volatility or fluctuations.
• Directional traders use variance trades to predict an asset’s future volatility; spread traders wager on the difference between realized and implied volatility; and hedge traders cover short volatility positions.
• Payoffs at maturity are positive if realized volatility is greater than the strike.