Key Takeaways
- Forward contract on future realized volatility.
- Cash-settled; no directional price risk.
- Payoff based on difference from strike volatility.
- Used for hedging or speculating on volatility.
What is Volatility Swap?
A volatility swap is a derivative contract that allows you to speculate or hedge on the future realized volatility of an underlying asset, such as a stock index or a single stock. Unlike a call option, it provides direct exposure to volatility without directional price risk.
This instrument settles in cash based on the difference between the realized volatility over the contract period and a predetermined volatility strike agreed at inception.
Key Characteristics
Volatility swaps offer unique features that differentiate them from other volatility-related instruments.
- Pure volatility exposure: They isolate volatility risk without exposure to price movements of the underlying asset.
- Cash-settled: Payoff depends on the difference between realized volatility and the volatility strike at maturity, with no physical delivery.
- Underlying assets: Commonly based on indices like the SPY ETF or single stocks with liquid options markets.
- OTC derivatives: Traded over-the-counter, leading to counterparty risk and requiring careful credit consideration.
- Relation to variance swaps: Volatility swaps are linked to variance swaps, but involve the square root of variance, making valuation and hedging more complex.
How It Works
At inception, the swap’s volatility strike is set to the implied volatility level, ensuring the initial value of the contract is zero. During the contract period, realized volatility is calculated from the underlying’s returns, typically using daily price data.
At maturity, the payoff equals the difference between realized volatility and the strike, multiplied by the volatility notional amount. If realized volatility exceeds the strike, the long volatility position profits; otherwise, it incurs a loss. This payoff structure allows traders to express views on volatility independent of price direction.
Examples and Use Cases
Volatility swaps are useful for hedging and speculative purposes across various sectors and market conditions.
- Equity markets: Investors might use volatility swaps on the SPY ETF to hedge against volatility spikes during uncertain macroeconomic events, such as changes in the macro-environment.
- Corporate risk management: Airlines like Delta use derivatives to manage fuel price and market volatility risks affecting their financials.
- Volatility arbitrage: Traders exploit differences between implied volatility embedded in options and realized volatility, adjusting positions dynamically to capture value.
- Portfolio hedging: Volatility swaps can complement option portfolios by providing a more direct hedge against tail risk events that cause sudden volatility surges.
Important Considerations
Keep in mind that volatility swaps carry counterparty risk due to their OTC nature, requiring you to assess the creditworthiness of the other party. Also, the realized volatility calculation depends heavily on data quality and model assumptions, which can introduce valuation uncertainty.
Because these swaps are sensitive to the volatility of volatility, hedging them often involves complex strategies and may require dynamic adjustments. To diversify volatility exposure effectively, you might consider combining volatility swaps with other instruments or ETFs, such as those highlighted in our best ETFs guide.
Final Words
Volatility swaps offer direct exposure to future volatility without price direction risk, making them powerful tools for hedging or speculation. To leverage their benefits effectively, analyze how realized volatility compares to implied levels in your target market before entering a contract.
Frequently Asked Questions
A volatility swap is a forward contract that allows two parties to exchange cash flows based on the difference between the realized volatility of an underlying asset and a predetermined volatility strike set at the start of the contract. It provides pure exposure to volatility without directional price risk.
At maturity, the payoff of a volatility swap depends on whether the realized volatility of the underlying asset exceeds or falls below the agreed-upon volatility strike. The payoff is calculated as the difference between realized volatility and the strike, multiplied by a volatility notional amount.
Volatility swaps typically reference liquid underlying assets such as stock indices like the S&P 500, single stocks, or foreign exchange rates, where there is active options market data to derive implied volatility for setting the strike.
Realized volatility is calculated as the annualized standard deviation of the underlying asset's returns over the contract period, usually using daily log returns and adjusting for the number of trading days in a year.
While variance swaps trade the realized variance directly, volatility swaps trade the square root of variance—realized volatility. This makes volatility swaps 'square-root derivatives' of variance swaps and requires more complex dynamic hedging due to volatility of volatility.
Traders use volatility swaps to speculate on future volatility levels, hedge existing volatility exposure, or trade the spread between implied and realized volatility without taking directional risk on the underlying asset's price.
The payoff at maturity is the product of the difference between realized volatility and the volatility strike and the volatility notional. If realized volatility exceeds the strike, the long position profits; if it falls short, the short position profits.
