Variance Swaps: Understanding Volatility Derivatives

Variance swap refers to an over-the-counter financial derivative that allows the holder to speculate on the future volatility of a given underlying asset. Holders use variance swaps to hedge their exposure to the magnitude of possible price movements of underliers, such as exchange rates, interest ratesFloating Interest RateA floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite of a fixed rate., or an equity index. The major benefit of variance swaps is that it does not require the investor to take directional exposure to the underlying asset.

Summary

• Variance swap refers to an over-the-counterOver-the-Counter (OTC)Over-the-counter (OTC) is the trading of securities between two counter-parties executed outside of formal exchanges and without the supervision of an exchange regulator. OTC trading is done in over-the-counter markets (a decentralized place with no physical location), through dealer networks. financial derivative that allows the holder to speculate on the future volatility of a given underlying asset.
• The major benefit of variance swaps is that it does not require the investor to take directional exposure to the underlying asset.
• They function in a manner that resembles a plain vanilla swap.

What is Variance?

Variance is a measure of the degree of difference between the expected price and actual price of an asset over time. Volatility is another more commonly used measure that is used to perform the same function in financial markets and media.

Volatility is derived from an asset’s variance. Generally, in percentage terms, an asset with higher volatility can be expected to be transacted more frequently.

How Do Variance Swaps Work

Variance swaps function in a manner that resembles a plain vanilla swap.

In a two-party transaction, one party is supposed to pay an amount that is based on the variance of price movements of the underlying asset. The other party must pay a fixed amount, which is also called the strike price. The strike price is predetermined, i.e., it is specified at the beginning of the contract.

The strike price is usually set such that the net present valueNet Present Value (NPV)Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. of the payoff becomes equal to zero. The net present value of an asset determined the current worth of an asset after considering the future cash inflow expected to be generated by that asset.

Mathematical Expression

At the end of the contract, the payoff available to both parties is a given amount multiplied by the actual variance and a given amount of volatility. Thus, if expressed mathematically, the variance swap is the arithmetic average of the differences from the mean value after it is squared. The variance is the square of the standard deviationStandard DeviationFrom a statistics standpoint, the standard deviation of a data set is a measure of the magnitude of deviations between values of the observations contained.

Advantages of Variance Swaps

• Options contracts function in a similar manner to variance swaps, but they carry multiple directional risks. Thus, they may require delta hedging. The contracts’ prices are dependent on many external factors, such as implied volatility, time, and date of expirationExpiration Date (Derivatives)The expiration date refers to the date in which options or futures contracts expire. It is the last day of the validity of the derivatives contract.. The additional risk is eliminated in variance swaps as the only external factor is the volatility of the underlying asset.
• The payout of a variance swap is typically higher than that of a volatility swap. It is because, unlike a volatility swap, the basis of a variance swap is variance instead of standard deviation.
• Variance swaps are a cheaper alternative to options because options equivalents involve the purchase of a strip of options.
• In a situation where the actual volatility of the underlying asset is more significant than the strike price, the payoff to the long holder on the date of maturity is always positive.

Disadvantage of Variance Swaps

Any unexpected jumps in the price of the underlying asset can skew the variance of the underlying asset, which can produce unexpected results.

Potential Users of Variance Swaps

1. Market users

Directional traders may use such instruments to speculate on the level of volatility of an asset. It is because variance swaps allow them to gain access to potentially profitable trading exposures. Spread traders may also bet on the difference between the actual volatility and implied volatilityImplied Volatility (IV)Implied volatility – or simply IV – uses the price of an option to calculate what the market is saying about the future volatility of the of the underlying asset. Hedger traders may use swaps in order to cover short volatility positions.

2. Other users

Investors may use variance contracts as a hedging vehicle in order to hedge against decreasing liquidity conditions. Insurance companies and options trading firms may want to offset their exposures to volatility in the markets.

Higher volatility is correlated to an increase in trading activity, which is usually beneficial for options trading firms. Convertible bond funds may use the same in order to hedge against a potential fall in volatility.

Related Readings

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