Key Takeaways
- Derivative on realized variance of an asset.
- Payoff depends on squared volatility differences.
- Easily replicated with vanilla options portfolio.
- Higher liquidity than volatility swaps.
What is Variance Swap?
A variance swap is a financial derivative that allows you to trade the future realized variance of an underlying asset, such as a stock index or commodity, without exposure to the asset’s price direction. Unlike a call option, it directly settles based on the squared volatility, providing a pure play on variance rather than price movements.
This instrument is commonly used for hedging or speculating on volatility, with its payoff depending on the difference between realized variance and the agreed strike variance over the contract period.
Key Characteristics
Variance swaps have distinct features that differentiate them from other volatility products:
- Underlying Measure: Based on realized variance calculated from squared daily log returns, making it mathematically the square of volatility.
- Cash-Settled: No upfront payment; settlement occurs at maturity by comparing realized variance to the fixed strike.
- Replication: Can be statically replicated with a portfolio of options, unlike volatility swaps that require dynamic hedging.
- Liquidity: Variance swaps generally have higher liquidity due to easier replication and demand from traders.
- Notional Amount: Expressed per variance point, allowing precise exposure control to volatility risk.
How It Works
At inception, you agree on a variance strike and notional amount, typically derived from market-implied volatility, so the swap has zero initial value. Throughout the contract, realized variance is measured daily using the underlying asset’s logarithmic returns, often annualized by the number of trading days.
At maturity, the payoff to the long variance position equals the notional multiplied by the difference between realized variance and the strike. For example, if realized variance exceeds the strike, you profit; if it is lower, you incur a loss. This payoff structure provides convex exposure to volatility spikes while limiting downside.
Examples and Use Cases
Variance swaps can be applied across various markets and sectors to manage risk or capitalize on volatility views:
- Equity Index Exposure: Traders may use variance swaps on indices like the IVV ETF to hedge or speculate on broad market volatility.
- Leveraged ETFs: Products such as SQQQ involve significant volatility exposure, where variance swaps can help manage tail risk effectively.
- Data Analytics Integration: Incorporating data analytics improves the accuracy of realized variance estimates, enhancing risk management strategies.
Important Considerations
While variance swaps offer pure volatility exposure, you should be mindful of model assumptions in strike setting and the impact of extreme market events on realized variance. Their convex payoff means that sudden volatility spikes can lead to large gains or losses, so risk management is critical.
Understanding how variance differs from volatility and monitoring tail events through tools like tail risk analysis helps you effectively utilize variance swaps in your portfolio.
Final Words
Variance swaps offer a precise way to trade future variance with greater liquidity and clearer replication strategies compared to volatility swaps. To leverage their benefits, analyze current market strikes and consider consulting with a derivatives specialist to structure a variance swap that fits your risk profile.
Frequently Asked Questions
A variance swap is a financial derivative contract where one party pays a fixed variance strike and the other pays the realized variance of an underlying asset over a set period. It is based on the squared volatility (variance) of the asset’s returns and settles in cash at maturity.
Variance swaps are based on realized variance, which is the square of volatility, making them easier to replicate with options and more liquid. Volatility swaps, on the other hand, are based on realized volatility itself, introducing convexity and requiring more complex hedging.
Variance swaps are more liquid because they can be statically replicated using a portfolio of vanilla options, making hedging straightforward and less model-dependent. Volatility swaps require dynamic hedging strategies and approximations, reducing their liquidity.
The payoff for the long position in a variance swap is the variance notional multiplied by the difference between the realized variance and the agreed variance strike. Essentially, it’s N_var × (realized variance - strike variance), with settlement in cash at contract maturity.
Realized variance is calculated as the annualized average of the squared daily log returns of the underlying asset’s price. This involves summing the squared logarithmic returns over the contract period and adjusting for the number of trading days.
Yes, variance swaps can be replicated using a static portfolio of out-of-the-money vanilla options across various strikes combined with delta hedging of the underlying asset, which reduces reliance on complex models.
Variance swaps can be written on a variety of underlying assets such as stock indices, individual stocks, commodities, and other financial instruments where volatility exposure is desired.
