A variance swap is a useful tool while investing. It is a financial derivative which allows one to speculate on or hedge risks associated with the magnitude of volatility, of some underlying product, like an exchange rate, interest rate, or stock index.
One aspect of the swap will pay an amount based upon the realized variance of the price changes of the underlying product. These price changes will be daily log returns, based upon the most commonly used closing price. The other aspect 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.
The features of a variance swap include:
- the variance strike
- the realized variance
- the Vega notional
USES :
1) The foremost 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.
2) The other big advantage 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.
FORMULA :
The payoff of a variance swap is given as follows:
where:
- Nvar = variance notional (a.k.a. variance units),
- = annualised realised variance, and
- = variance strike.